Trading Frequency and Information Efficiency: Theory and Evidence from US and Chinese Markets

Abstract

This paper analyzes the relation between price informativeness and trading frequency. We develop a sequential trading model to capture the tradeoff between trading more frequently and acquiring more information. The key component of the model is the cost of information collection and processing. When information flow comes sequentially, traders must give up some early trading opportunities if they want to acquire more information. We show that more trading opportunities may induce informed traders to participate in more trades before obtaining more accurate information. Consequently, when informed traders trade more frequently, less information is impounded into prices. Empirical tests using stocks listed on NYSE, as well as the Shanghai Stock Exchange and the Shenzhen Stock Exchange, support the two testable implications of our model — a negative relation between the quality of the information environment and informed traders’ trading frequency, and a negative relation between informed traders’ trading frequency and price informativeness. One implication of our model and empirical results is that a decrease in excessive trading activities may help shift market participants’ attention from short-term price movements to companies’ fundamental information so that the information could be more efficiently impounded into prices, which, in turn, may further lead toward better resource allocation in financial markets.

Keywords: Information acquisition, Trading frequency, Price efficiency

JEL Classification: G14