Self-Referential Trading Feedback, Market Conventions, and Overreaction

Summary

This paper models how traders can create feedback by estimating correlations between market information and prices from past data, then using those correlations to guide trades. When enough agents act on the estimated relationship, their orders alter prices and therefore change the correlation they originally relied on. The resulting feedback can destabilize otherwise efficient behavior.

The model predicts a threshold beyond which nonzero correlations emerge spontaneously and markets switch between persistent states, or conventions. When price history is the information source, these states correspond to trend following and contrarian, mean-reverting behavior. The authors connect the convention phase with overreaction and potentially substantial excess volatility, and report empirical evidence that such regimes may persist in real markets for decades. The provided description does not specify the datasets or estimation method behind that evidence, so it does not establish how reliably traders can identify or exploit these states.

Key ideas

• Traders acting on historically estimated correlations can change the prices used to estimate those same correlations.
• Sufficiently strong feedback can produce a transition from efficient behavior to persistent market conventions.
• When price itself is the signal, conventions can take trend-following or contrarian forms.
• The model links these regimes to overreaction and excess volatility.
• The authors cite evidence of long-lasting conventions in real markets, but the summary gives no data or identification details.

Tags

# Self-referential behaviour, overreaction and conventions in financial markets


# Self-referential behaviour, overreaction and conventions in financial markets









We study a generic model for self-referential behaviour in financial markets, where agents attempt to use some (possibly fictitious) causal correlations between a certain quantitative information and the price itself. This correlation is estimated using the past history itself, and is used by a fraction of agents to devise active trading strategies. The impact of these strategies on the price modify the observed correlations. A potentially unstable feedback loop appears and destabilizes the market from an efficient behaviour. For large enough feedbacks, we find a `phase transition' beyond which non trivial correlations spontaneously set in and where the market switches between two long lived states, that we call conventions. This mechanism leads to overreaction and excess volatility, which may be considerable in the convention phase. A particularly relevant case is when the source of information is the price itself. The two conventions then correspond then to either a trend following regime or to a contrarian (mean reverting) regime. We provide some empirical evidence for the existence of these conventions in real markets, that can last for several decades.

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.