Technical Trading with Imperfect Competition

Abstract

Technical analysis (TA) is modeled as a method to infer market liquidity demand. Risk-averse market makers supply immediacy to an informed trader and uninformed technical traders, who conduct TA and trade strategically, and to liquidity traders, who trade randomly. Price change is positively related to both market liquidity demand and its change (order imbalance) when technical traders trade. Informed and technical traders’ technical trading (i.e., trading based on TA) tends to offset the previous order imbalance (similar to asynchronized trading in Grossman and Miller, 1988), and generates negative return autocorrelations. As the number of technical traders increases, price impact declines and price informativeness improves, but successive return autocovariances and autocorrelations become more negative.

Keywords: Technical analysis; market liquidity demand; risk-averse market makers; imperfect competition.

JEL Classification: D4, D82, D84, G11, G12, G14