Market Impact and Momentum in Self-Reinforcing Trading Feedback

Summary

The document uses an agent-based model to study how market impact and momentum traders shape price fluctuations and trading strategies. Its central finding is that the effect of momentum depends on the level of market impact. When impact is low, momentum traders have little effect on price fluctuations but can upset the balance between trend-following and trend-rejecting strategies, allowing herding and a self-reinforcing feedback loop to emerge.

With high market impact, momentum traders increase price fluctuations. Trend-following by rational agents is suppressed while momentum traders’ trend-following grows, and crowd-versus-anticrowd behavior leads to negative feedback. The theoretical analysis links these patterns to traders’ outcomes: trend followers benefit from majority behavior at low impact but suffer losses under minority behavior at high impact. These are model-based mechanisms; the document does not describe empirical market validation or quantify the conditions separating the regimes.

Key ideas

• The agent-based model combines market impact with momentum trading to study feedback loops.
• At low market impact, trend-following herds can create self-reinforcing feedback.
• At high market impact, volatility rises and negative feedback becomes dominant.
• The model links strategy prevalence to whether trend followers gain as a majority or lose as a minority.

Tags

# Self-reinforcing feedback loop in financial markets with coupling of market impact and momentum traders


# Self-reinforcing feedback loop in financial markets with coupling of market impact and momentum traders









By incorporating market impact and momentum traders into an agent-based model, we investigate the conditions for the occurrence of self-reinforcing feedback loops and the coevolutionary mechanism of prices and strategies. For low market impact, the price fluctuations are originally large. The existence of momentum traders has little impact on the change of price fluctuations but destroys the equilibrium between the trend-following and trend-rejecting strategies. The trend-following herd behaviors become dominant. A self-reinforcing feedback loop exists. For high market impact, the existence of momentum traders leads to an increase in price fluctuations. The trend-following strategies of rational individuals are suppressed while the trend-following strategies of momentum traders are promoted. The crowd-anticrowd behaviors become dominant. A negative feedback loop exists. A theoretical analysis indicates that, for low market impact, the majority effect is beneficial for the trend-followers to earn more, which in turn promotes the trend-following strategies. For high market impact, the minority effect causes the trend-followers to suffer great losses, which in turn suppresses the trend-following strategies.

Shown in full with attribution under the source's licence. Licence: abstract CC0

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.