Determinants of Trading Profits of Individual Traders: Risk Premia or Information?

Abstract

Using a unique proprietary data set of trades by all large traders in the crude oil, gasoline, and heating oil futures markets, we explore determinants of their individual trading profits/losses. Consistent with the risk premium hypothesis, hedgers’ mean trading profits are significantly negative while speculator’s trading profits (hedge funds especially) are significantly positive. Moreover, the profits of individual traders (whether speculators or hedgers) are a strong positive function of the extent to which the trader shorts (longs) when likely hedgers in the aggregate are long (short). While some individual traders may have an informational advantage, the trading profits of speculators in general and hedge funds in particular are due to their employing trading strategies which take advantage of the risk premium, i.e., longing (shorting) when hedgers in the aggregate are net short (long). Thus our evidence indicates that speculator profits are primarily due to the liquidity and risk absorption services they provide hedgers. Market makers realize significant losses on their overnight holdings, which is consistent with findings in prior studies for other markets that any information advantages they may possess are short-lived. We also find that (excepting households) speculator profitability is a positive function of the rates at which speculators turn over their portfolios.