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Answer: A majority of large investors increasingly follow a trend-following trading strategy
## Explanation **A is correct.** This is an example of positive feedback trading, where investors trade in the direction of the market. Positive feedback trading can create liquidity black holes because when many investors follow trend-following strategies, they all buy during uptrends and sell during downtrends simultaneously, amplifying price movements and reducing market liquidity. **B is incorrect.** These two trades would not contribute to creating a black hole since the delta neutral hedge for a sale of put options is a sale of stock while the brokerage firm's additional purchase of call options would require the brokerage firm's counterparty to purchase shares for their own delta neutral hedge. **C is incorrect.** Selling stocks after they appreciate would not destabilize the market, and the use of limit orders would not be further destabilizing because they will only trigger if the limit is reached. **D is incorrect.** Narrowing spreads indicate greater liquidity, not decreasing liquidity. **Key Concept:** Liquidity black holes occur when market participants' trading strategies become correlated, leading to simultaneous buying or selling that overwhelms market liquidity. Positive feedback trading is a primary driver of such scenarios.
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A national regulator is developing a set of indicators to serve as warning signs that the liquidity of the stock market could be decreasing. The regulator is particularly concerned about the potential for a "liquidity black hole" to develop which could destabilize the stock market. Which of the following observations would be of greatest concern to the regulator as a signal of a potential liquidity black hole occurring?
A
A majority of large investors increasingly follow a trend-following trading strategy
B
Brokerage firms purchase call options as a hedge against the sale of a large number of put options to institutional investors.
C
Portfolio managers sell stocks that have increased in value and reached their price target.
D
Bid-ask spreads for less liquid stocks become narrower.
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