Strategic Trading with Naive Noise Traders

42 Pages Posted: 10 Jan 2004

See all articles by F. Albert Wang

F. Albert Wang

University of Dayton - School of Business Administration - Department of Economics and Finance

Date Written: December 30, 2003

Abstract

We investigate a dynamic model of speculative trading in which a naive noise trader is born each period who uses a simple strategy, whereas a rational informed investor maximizes her profits by strategically exploiting the successive noise trading over time. The model shows that the two types of traders will soon hold opposite views on whether the current price is high or low relative to its fundamental value. The informed trader simultaneously submits an "information trade" to exploit asymmetric information and an "arbitrage trade" to exploit heterogeneous beliefs between the two types every period. The heterogeneous beliefs render a unique source of liquidity, thus magnifying informed profits and the total trading volume. It is shown that a monopolistic informed trader may ride on noise trading in early periods to push the price away from its fundamental value, only to reap greater profits by her later arbitrage trades. Such strategic behavior in arbitrage, however, disappears under imperfect competition. Unlike previous models with exogenous noise (liquidity) trading, our model with endogenous noise trading can better explain the high trading volume phenomenon and the familiar U-shaped pattern in intraday transaction costs and price volatility.

Suggested Citation

Wang, Fukuo Albert, Strategic Trading with Naive Noise Traders (December 30, 2003). Available at SSRN: https://ssrn.com/abstract=484982 or http://dx.doi.org/10.2139/ssrn.484982

Fukuo Albert Wang (Contact Author)

University of Dayton - School of Business Administration - Department of Economics and Finance ( email )

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Dayton, OH 45469
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