This exercise is related to a trading practice called quote matching, which occurs when a small trader places an order one uptick (downtick) from that of a large trader so as to profit from the large trader’s transaction upward (downward) price pressure, or to use the large trader as a trade counterparty should prices decrease (increase). Suppose that Stock X has just sold for $10.05. An institutional investor places a limit order to purchase 1 million shares at $10.00, which is now the best bid. The best offer is currently $10.10. A trader, who reasons that the stock is equally likely to have an intrinsic value (true worth) of either $10.00 or $10.10 (E[V] = $10.05), places a limit order to buy 200,000 shares of the stock for $10.01.

a. Describe how the trader is attempting to exploit the options provided by the spread.

b. How might the institutional investor be losing wealth as a result of his limit order?