Technical Trading with Imperfect Competition

Abstract

This paper examines the usefulness of technical analysis (TA) from the perspective of detecting market liquidity demand. An informed trader and a number of uninformed technical traders employ TA and trade strategically with liquidity traders and risk-averse market makers in a dynamic equilibrium model. TA is a feasible mechanism to generate asynchronized trading described in Grossman and Miller (1988). Technical trading (i.e., trading based on TA) of the informed trader and technical traders induces negative return autocorrelations. As the number of technical traders increases, although market quality enhances, successive return autocorrelations become more negative; market makers trade more like short-term investors; the informed trader can be either better or worse off.

Keywords: Technical trading, liquidity provision, risk-averse market makers

JEL Classification: D82, G11, G14