PROFITABILITY AND MARKET STABILITY: FUNDAMENTALS AND TECHNICAL TRADING RULES

Traders in this simulation of an asset market endogenously select from available information sources in order to maximize expected profits. The information options include two noisy signals of future dividends (the fundamentals) and a simple trend following technical trading rule. Traders use the information for constructing a portfolio to hold through to the next period, consisting of a risky and a risk free asset . Due to free riding on information conveyed in the market price, the technical trading rule proves to be profitable when the market is near the fundamental equilibrium. Popularity of the technical trading rule alters the price dynamics and can move the price away from this equilibrium.The tradersÆ selection of an information source is modeled as a randomized discrete choice. The greater the expected relative benefit of an information source, the greater the probability of its selection. The intensity of choice parameter sets the tradersÆ sensitivity to expected benefits and plays a major role in determining market dynamics. In forming expected benefits of the fundamental information, traders are forward looking using current market observables. The technical trading rule is evaluated based on past performance. Once traders have selected an information source, demand for the risky asset is aggregated within each information source. A price is determined to clear the market.Depending on the intensity of choice setting, computer simulations of the market can result in growth in the popularity of the technical trading rule following a series of correct signals. The larger population of technical traders causes distortions in the market price which may lead to price bubbles. The price bubble contributes to the popularity of the trading rule while simultaneously moving the market further from the fundamental equilibrium. The eventual collapse of the bubble creates windfall profits for the remaining population of fundamental traders while the losses reduce the popularity of the technical trading rule. The market returns to the fundamental equilibrium allowing the cycle to begin again.Two self-fulfilling regimes exist, each resulting in different market dynamics. If traders believe that the distortionary impact the technical traders excerpt on the market price will continue, then the decision concerning information selection and the trading behavior of those who choose to rely on the fundamental information both serve to perpetuate the trading rule and its influence on price. Alternately, if the traders believe that any distortions will soon dissipate, then traders will be attracted to fundamental information when they suspect a deviation from fundamentals. Those selecting to use fundamental information will trade aggressively to exploit the distortion. These behaviors forces the price back towards the fundamental equilibrium. The market has a decreased tendency to develop large price bubbles in the latter regime, but smaller high frequency price oscillations continue. Current efforts include endogenizing the tradersÆ beliefs about which regime is in effect.A second observation addresses the evolutionary development of successful technical trading rules. In a market consisting exclusively of fundamental traders, the only type of technical trading rule which is able to exploit price patterns are trend following rules such as those initially examined. The distortions in price caused by the popularity of a trend following rule creates an environment in which different categories of rules may be useful. A price-dividend rule is examined. Though useless when the market is exclusively fundamental traders, the price dividend rule proves profitable in the market experiencing the distortions caused by the trend following rules.