Speculative Trading, Prospect Theory and Transaction Costs

25 Pages Posted: 10 Dec 2019

See all articles by Alex S. L. Tse

Alex S. L. Tse

University of Exeter Business School

Harry Zheng

Imperial College London - Mathematical Finance

Date Written: November 22, 2019

Abstract

A speculative agent with Prospect Theory preference chooses the optimal time to purchase and then to sell an indivisible risky asset as to maximize the expected utility of the round-trip profit net of transaction costs. The optimization problem is formulated as a sequential optimal stopping problem and we provide a complete characterization of the solution. Depending on the preference and market parameters as well as the initial price of the asset, the optimal strategy can be "buy and hold", "buy low sell high", "buy high sell higher" or "no trading". Transaction costs do not necessarily curb speculative trading. For example, while a large proportional transaction cost on sale can unambiguously suppress trading participation, introducing a fixed market entry fee will indeed encourage trading when the asset price level is high.

Keywords: S-shaped utility, optimal stopping, transaction costs, entry-and-exit strategies

JEL Classification: C41, G11, G40

Suggested Citation

Tse, Alex S. L. and Zheng, Harry, Speculative Trading, Prospect Theory and Transaction Costs (November 22, 2019). Available at SSRN: https://ssrn.com/abstract=3491947 or http://dx.doi.org/10.2139/ssrn.3491947

Alex S. L. Tse (Contact Author)

University of Exeter Business School ( email )

University of Exeter Business School
Rennes Drive
Exeter, Devon EX4 4PU
United Kingdom

Harry Zheng

Imperial College London - Mathematical Finance ( email )

United Kingdom

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