Mark Bedau, Shareen Joshi, Jeffrey Parker

Paper #: 98-12-115

The widespread use and proven profitability of technical trading rules in financial markets has long been a puzzle in academic finance. In this paper we show, using an agent-based model of an evolving stock market, that widespread technical trading can arise due to a multi-person Prisoner’s Dilemma in which the inclusion of technical trading rules to a single agent’s repertoire of rules is a dominant strategy. The use of this dominant strategy by all traders in the market creates a symmetric Nash equilibrium in which wealth earned is lower and the volatility of prices is higher than in the hypothetical case in which all agents rely only on fundamental rules. Our explanation of this lower wealth and higher volatility is that the use of technical trading rules worsens the accuracy of the predictions of all agents’ market forecasts by contributing to the reinforcement of price trends, augmenting volatility, and increasing the amount of noise in the market.