Trading volume after an inside information warning
Question
Twenty traders only trade among themselves, covering 100 stocks. A regulator announces that one of these traders holds inside information about one of the stocks, without saying who or which stock. What do you expect to happen to trading volume?
Short answer
It should fall sharply, potentially towards zero. Trading among a closed group is zero-sum; once everyone knows a counterparty might be informed, any trade could be with the insider (adverse selection). Uninformed traders widen quotes or refuse to trade, and since nobody knows which stock is affected the chill spreads across all 100 names. Only trades needed for liquidity or hedging reasons persist.
Adapted from Crack, Heard on the Street, Q3.18, p.36; question and answer rewritten by SelfMadeQuant.com.
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