Journal of Economic Behavior & Organization

Vol. 49 (2002) 149171

The price dynamics of common trading strategies

J. Doyne Farmer a, , Shareen Joshi b
a Santa Fe Institute, 1399 Hyde Park Road, Santa Fe 87501, USA
b Economics Department, Yale University, New Haven, USA

Received 9 April 2001; received in revised form 20 September 2001; accepted 4 October 2001

Abstract
A deterministic trading strategy can be regarded as a signal processing element that uses external
information and past prices as inputs and incorporates them into future prices. This paper uses a
market maker based method of price formation to study the price dynamics induced by several
commonly used financial trading strategies, showing how they amplify noise, induce structure in
prices, and cause phenomena such as excess and clustered volatility. 2002 Published by Elsevier
Science B.V.
Keywords: Price dynamics; Trading strategy; Value investors

1. Introduction

1.1. Motivation

Under the efficient market hypothesis prices should instantly and correctly adjust to reflect
new information. There is evidence, however, that this may not be the case: the largest price
movements often occur with little or no news (Cutler et al., 1989), price volatility is strongly
temporally correlated (Engle, 1982), short-term price fluctuations are non-normal,1 and
prices may not accurately reflect rational valuations (Campbell and Shiller, 1988). This
suggests that markets have non-trivial internal dynamics. Traders may be thought of as
signal processing elements, that process external information and incorporate it into future
prices. Insofar as individual traders use deterministic decision rules, they act as signal
filters and transducers, converting random information shocks into temporal patterns in
prices. Through their interaction they can amplify incoming noisy information, alter its
distribution, and induce temporal correlations in volatility and volume.
Corresponding author.

E-mail address: [email protected] (J.D. Farmer).

1 See, e.g. Mandelbrot (1963, 1997), Lux (1996), Mantegna and Stanley (1999).

0167-2681/02/$ see front matter 2002 Published by Elsevier Science B.V.

PII: S 0 1 6 7 - 2 6 8 1 ( 0 2 ) 0 0 0 6 5 - 3
150 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171

This paper2 investigates a simple behavioral model for the price dynamics of a few,
common archetypal trading strategies. The goal is to understand how these strategies affect
prices. There are three groups of agents: value investors (or fundamentalists) who hold an
asset when they think it is undervalued and short it when it is overvalued; trend followers
(a particular kind of technical trader, or chartist), who hold an asset when the price has
been going up and sell it when it has been going down; and market makers, who absorb
fluctuations in excess demand, lowering the price when they have to buy and raising it
when they have to sell. These are of course only a few of the strategies actually used in
real markets. But they are known to be widely used (Keim and Madhaven, 1995; Menkhoff,
1998), and understanding their influence on prices provides a starting point for more realistic
behavioral models.

1.2. Relation to previous work

The first behavioral model that treats the dynamics of trend followers and value investors
that we are aware of is due to Beja and Goldman (1980). Assuming linear trading rules
for each type of trading, they showed that equilibrium is unstable when the fraction of
trend followers is sufficiently high. A related model using non-linear investment rules was
introduced by Day and Huang (1990), who added market makers, modified the strategies,
and demonstrated chaotic dynamics for prices. The Beja and Goldman model was extended
by Chiarella (1992), who made the trend following rule non-linear. When the fraction of
trend followers is sufficiently low, the equilibrium is stable, but when it exceeds a critical
value it becomes unstable, and is replaced by a limit cycle. The excess demand of each
trader type oscillates as the cycle is traversed, causing sustained deviations from the equi-
librium price. This model was further enhanced by Sethi (1996), who studied inventory
accumulation, cash flow, and the cost of information acquisition. He showed that for cer-
tain parameter settings the money of trend followers and value investors oscillates, and
when trend followers dominate there are periods where the amplitude of price oscillations
is large. Except for some remarks by Chiarella, this work is done in a purely deterministic
setting.
Studies along somewhat different lines have been made by Lux (1997, 1998), Lux and
Marchesi (1999), and also by Brock and Hommes (19971999). Both study the effect
of switching between trend following and value investing behavior. Brock and Hommes
assume market clearing, and focus their work on the bifurcation structure and conditions
under which the dynamics are chaotic. The Lux et al. papers use a disequilibrium method
of price formation, and focus their work on demonstrating agreement with more realistic
price series. They also assume a stochastic value process, and stress the role of the market
as a signal processor. Bouchaud and Cont (1998) introduced a Langevin model, which
is closely related to the work presented here.3 These are not the only studies along these
lines; for example, see Goldbaum (1999), or for brief reviews see LeBaron (in press) or
Farmer (1999).

2 Many of these results originally appeared in preprint form in Farmer (1998).

3 Many of results in this paper were presented at a seminar at Jussieu in Paris in June 1997. Bouchaud and Cont
(1998) acknowledge their attendance in a footnote.
 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171 151

The model discussed here was developed independently, and takes this study in a some-
what different direction. Like Day and Huang (1990) and Day (1994), we explicitly include a
market maker.4 We modify their model by assuming a simpler price formation rule, explore
several different fundamentalist investment strategies, study a more general trend following
strategy, and most importantly, we study stochastic information shocks and fundamental
values. The use of a market maker allows us to study the price dynamics of each trading
strategy individually, i.e. in a setting that includes only that strategy, the market maker, and
noisy inputs. We characterize the noise amplification and price autocorrelations caused by
each strategy. We investigate simple linear strategies analytically, and also present some
numerical results for a heterogeneous market with more complicated non-linear strategies.

2. Price formation model

In most real markets changes in the demand of individual agents are expressed in terms
of orders. To keep things simple, we assume market orders, which are requests to transact
immediately at the best available price. The fill price for small market orders is often quoted,
so that it is known in advance, but for large market orders the fill price is unknown. This
implies that transactions occur out of equilibrium.

2.1. Model framework

The goal of this section is to derive a reasonable market impact function (sometimes
also called a price impact function) that relates the net of all such orders at any given time
to prices. We assume there are two broad types of financial agents, trading a single asset
(measured in units of shares) that can be converted to money (which can be viewed as a
risk free asset paying no interest). The first type of agents are directional traders. They buy
or sell by placing market orders, which are always filled. In the typical case, the buy and
sell orders of the directional traders do not match, the excess is taken up by the second
type of agent, who is a market maker. The orders are filled by the market maker at a price
that is shifted from the previous price, by an amount that depends on the net order of the
directional traders. The market impact function is the algorithm that the market maker uses
to set prices. Since buying drives the price up and selling drives it down, must be an
increasing function.
Let there be directional traders, labeled by the superscript, holding shares at time. For
simplicity we assume synchronous trading at times . . . , t 1, t, t +1, . . . . Let the position of
(i) (i) (i)
the ith directional trader be a function, xt+1 = x (i) (Pt , Pt1 , . . . It ), where It represents
any additional external information. The function x(i) can be thought of as the strategy or
(i)
decision rule of agent. The order t is determined from the position through the relation
(i) (i) (i)
t = xt xt1 (1)

4 Empirical studies of market clearing give half-lives for market maker inventories on the order of a week

(Hansch et al., 1998). This suggests that the lack of market clearing can be important on short timescales up to
1 month or so.
152 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171

A single timestep in the trading process can be decomposed into following two parts:
1. The directional traders observe the most recent prices and information at time and submit
(i)
orders t+1 .
2. The market maker fills all the orders at the new price Pt +1 .
To keep things simple, we will assume that the price is a positive real number, and that
positions, orders, and strategies are anonymous. This motivates the assumption that the
market maker bases price formation only on the net order
N


= (i)
i=1

The algorithm the market maker uses to compute the fill price for the net order is an
increasing function of,
Pt+1 = f (Pt , ) (2)

The fact that the new price depends only the current order, and not on the accumulated
inventory of shares held by the market maker, implies that the market maker must be risk
neutral.

2.2. Derivation of market impact function

An approximation of the market impact function can be derived by assuming that is of

the form
f (Pt , ) = Pt () (3)

where is an increasing function with (0) = 1. Taking logarithms and expanding in a

Taylors series, providing the derivative  (0) exists, to leading order

log Pt+t log Pt (4)

This functional form for will be called the log-linear market impact function. Parameter
is a scale factor that normalizes the order size, and will be called the liquidity. Parameter
is the order size that will cause the price to change by a factor of e, measured in units
of shares. Note that this is similar to the price formation rule derived by Kyle (1985), with
the important difference that the price P is replaced by log P. This guarantees that prices
remain positive. The log-linear rule is simply a convenient approximation. Indeed, several
different empirical studies suggest that the shift in the logarithm of the price shift plotted
against order size is a concave non-linear function.5
For an equilibrium model the clearing price depends only on the current demand functions.
In contrast, if prices are determined based on market impact using Eq. (3), in the general
5 For discussions of empirical evidence concerning market impact see Hausman and Lo (1992), Chan and

Lakonishok (1993, 1995), Campbell et al. (1997), Torre (1997) and Keim and Madhaven (1999). Zhang (1999)
has offered a heuristic derivation of nonlinear market impact rule.
 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171 153

case they are path dependent. That is, the price at any given time depends on the starting
price as well as the sequence of previous net orders. The log-linear rule is somewhere in
between: the price change over any given period of time depends only on the net order
imbalance during that time. In fact, we can show that this property implies the log-linear
rule: suppose we require that two orders placed in succession result in the same price as a
single order equal to their sum, i.e.
f (f (P , 1 ), 2 ) = f (P , 1 + 2 ) (5)
By grouping orders pairwise, repeated application of Eq. (5) makes it clear that the price
change in any time interval only depends on the sum of the net orders in this interval.
Substituting Eq. (3) into Eq. (5) gives
(1 + 2 ) = (1 )(2 )
This functional equation for has the solution
() = e/ (6)
which is equivalent to Eq. (4). Other possible solutions are () = 0 and () = 1 but
neither of these satisfy the requirement that is increasing.
There is an implicit assumption that the market is symmetric in the sense that there is no
a priori difference between buying and selling. Indeed, with any price formation rule that
satisfies Eq. (5) buying and selling are inverse operations (this is clear by letting 2 = 1 ,
which implies that f 1 (P , ) = f (P , )). This is reasonable for currency markets and
many derivative markets, but probably not for most stock markets.6

2.3. Dynamics

We can now write down a dynamical system describing the interaction between trading
decisions and prices. Letting pt = log Pt , and adding a noise term t +1 , Eq. (4) becomes
N
1
(i)
pt+1 = pt + (pt , pt1 , . . . , It ) + t+1 (7)

i=1

To complete the model we need to make the functions (i) used by agent i explicit. Note
that from Eq. (1), (i) is automatically defined once the function x(i) is given.
The addition of the random term t can be interpreted in one of two ways: it can be
thought of as corresponding to noise traders, or liquidity traders, who submit orders at
random, in which case it should be divided by . Alternatively, it can be thought of as simply
corresponding to random perturbations in the price, for example random information that
affects the market makers price setting decisions. By using the form in Eq. (7) we take the
latter interpretation.
6 The short selling rules in the American market are an example of a built-in asymmetry. From an empirical

point of view for American equities the market impact of buying and selling are different, as observed by Chan
and Lakonishok (1993, 1995). Such asymmetries can be taken into account by in terms of a different liquidity for
buying and selling.
154 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171

In this model the number of shares is conserved, i.e. every time an agent buys a share
another agent loses that share. Thus, the sum of all the agents positions are constant,
providing the market makers position is included. All the agents, including the market
maker, are free to take arbitrarily large positions, including net short (negative) positions.
Thus, they are effectively given infinite credit. We have studied the wealth dynamics of
different strategies in some detail, but this is reported elsewhere (Farmer, 1998).

3. Agent behaviors

We now describe some trading strategies in more detail and study their price dynamics.
Since the market maker is in a sense a neutral agent, we can begin by studying each strategy
trading against the market maker. Each strategy induces characteristic price dynamics which
can be characterized by its autocorrelation and noise amplification.
One approach to classifying financial trading strategies is based on their information
inputs. Decision rules that depend only on the price history are called technical or chartist
strategies. Trend following strategies are a commonly used special case in which positions
are positively correlated with recent price changes. Value or fundamental strategies, in con-
trast, are based on external information leading to a subjective assessment of the long-term
fundamental value. Investors using these strategies do not believe this is the same as the
current price. Pure technical strategies can be thought of as signal filters: they accept past
prices as inputs and transform future prices. Value strategies, in contrast, are primarily signal
transducers: they use external value signals as inputs and, through their trading, incorporate
them into prices.

3.1. Trend followers

Trend followers, also sometimes called positive-feedback investors (DeLong et al., 1990),
invest based on the belief that price changes have inertia. A trend strategy takes a positive
(long) position if prices have recently been going up, and a negative (short) position if they
have recently been going down. More precisely, a trading strategy is trend following on
timescale if the position has a positive correlation with past price movements on timescale
, i.e.
(xt+1 , (pt pt )) > 0
A strategy can be trend following on some timescales but not on others.
An example of a simple linear trend following strategy, which can be regarded as a
first-order Taylor approximation of a general trend following strategy is
xt+1 = c(pt pt ) (8)
where c > 0. Note that if we let c < 0 this becomes a contrarian strategy. Letting the
log-return rt = pt pt1 , from Eq. (7), the induced dynamics are
rt+1 = (rt rt ) + t (9)
where = (c/) > 1 and rt = pt pt . Fig. 1 shows a series of prices with = 0.2
and = 10.
 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171 155

Fig. 1. Log-price vs. time for trend followers with = 0.2 and = 10 (Eq. (9)). Trend followers tend to induce
short-term trends in prices, but they also cause oscillations on longer timescales.

The stability of the dynamics can be calculated by writing Eq. (9) in the form ut+1 = Aut ,
where ut = rt , . . . , rt , and computing the eigenvalues of A. For = 1 these are

(1 ) 5 2 + 2
=
2
The dynamics are stable when < 1.
Trend strategies overall amplify the noise in prices. This is reflected in the variance of
the log-returns, which is computed by taking the variance of both sides of Eq. (9).

2
r2 =
1 2 2 (1 r ( ))

r2 is the variance of log-returns, and 2 is the variance of the noise t . Since the autocor-
relation of log-returns, r ( ) 1, it follows that r > . Regardless of the value of or
r , the variance of the price fluctuations is larger than of the noise driving term. However,
note that this is also true for a contrarian strategy: reversing the sign of c in Eq. (8) leaves
this result unchanged. Thus, we see that either trend or contrarian strategies can contribute
to excess volatility by amplifying noise in prices.
Trend strategies induce trends in the price, but as we show below, they can also have other
side effects. For example, consider Fig. 2, which shows the autocorrelation function for the
return series of Fig. 1. The decaying oscillations between positive and negative values are
characteristic of trend strategies with large lags. For = 1 the autocorrelation function is
of order . As increases it decays, crossing zero at roughly (/2) + 1. As continues
to increase it becomes negative, reaching a minimum at + 1, where it is of order .
The autocorrelation then increases again, reaching a local maximum at = 2 + 2, where it
is of order 2 . As increases still further it oscillates between positive and negative values
with period, decaying by a factor of with every successive period.
156 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171

Fig. 2. The autocorrelation function for Eq. (9) with = 0.2 and = 10. The positive coefficients for small
indicate short-term trends in prices, and the negative coefficients indicate longer-term oscillations.

This behavior can be understood analytically. A recursion relation for the autocorrelation
function can be obtained by multiplying Eq. (9) by rt n , subtracting the mean, and averaging,
which gives
r (n + 1) = (r (n) r (|n |)) (10)
Doing this for n = 0, . . . , 1 gives a system of linear equations that can be solved for
the first values of r ( ) by making use of the requirement that r (0) = 1. The remainder
of the terms can be found by iteration. For example, for = 1, for = 1, . . . , 6, for the
autocorrelation function is
1
r ( ) = (, , 2 2 , 2 (1 2) 3 (3 2), 4 (3 2)) (11)
1+
Solving this for a few other values of demonstrates that the first autocorrelation r (1) is
always positive and of order , but r ( + 1) is always negative of order . For large
and small , using Eq. (10) it is easy to demonstrate that the autocorrelation follows the
behavior described earlier. For + 1, to leading order in, ( ) | 1|+1 .
Representing this in frequency space adds insight into how trend strategies affect prices.
The power spectrum of the returns can be computed by taking the cosine transform of the
autocorrelation function, or alternatively, by computing the square of the Fourier transform
of the log-returns and averaging. The result is shown in Fig. 3. We see that the power spec-
trum has a large peak at frequency 2 + 2, with peaks of decreasing amplitude at the odd
harmonics of this frequency. The amplitude of the peaks is greater than one, indicating that
the trend strategy amplifies noise at these frequencies. However, the troughs, which occur at
the even harmonics, have amplitude less than one, indicating that the trend strategy damps
noise at these frequencies. When viewed as a signal processing element, the trend strategy is
essentially a selective low frequency noise amplifier, which induces oscillations at frequen-
cies related to the time horizon over which trends are evaluated. The detailed properties are
specific to this particular trend rule; in particular, the oscillations in the spectrum are caused
 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171 157

Fig. 3. Power spectrum of returns induced by a trend following strategy. Same parameters as Fig. 2.

by the fact that this trend rule uses a moving average with a sharp cut-off. However, the basic
property of amplifying low frequency noise is present in all the trend rules we have studied.

3.2. Value investors

Value investors make a subjective assessment of value in relation to price. They believe
that their perceived value may not be fully reflected in the current price, and that future prices
will move toward their perceived value. They attempt to make profits by taking positive
(long) positions when they think the market is undervalued and negative (short) positions
when they think the market is overvalued.
In a homogeneous equilibrium setting in which everyone agrees on value, price and value
are the same. In a non-equilibrium context, however, prices do not instantly reflect values
there can be interesting dynamics relating the two. Indeed many authors, such as Campbell
and Shiller (1988), have suggested that prices may not track rational valuations very well,
even in liquid markets, and that in some cases the differences can be substantial.
For the purposes of this paper it does not matter how individual agents form their opinions
about value.7 We take the estimated value as an exogenous input, and focus on the response
7 They could, for example, use a standard dividend discount model, in which case their valuations depend on

their forecasts of future dividends and interest rates. The results here, however, are independent of the method of
valuation.
158 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171

of prices to changes in it. Let the logarithm of the value t be a random walk:
t+1 = t + t+1 (12)

where t is a normal, IID noise process with standard deviation and mean . We will
begin by studying the case where everyone perceives the same value, and return to study
the case where there are diverse views about value in Section 3.2.5.
The natural way to quantify whether price tracks value is by using the concept of cointegra-
tion, introduced by Engle and Granger (1987). This concept is motivated by the possibility
that two random processes can each be random walks, even though on average they tend
to move together and stay near each other. More specifically, two random processes yt and
zt are cointegrated if there is a linear combination ut = ayt + bzt that is stationary. For
example, the log-price and log-value are cointegrated if pt t has a well-defined mean
and standard deviation.

3.2.1. Simple value strategies

For the simplest class of value strategies the position is of the form
xt+1 = x(t , pt ) = V (t pt ) (13)

where V is an increasing function with V (0) = 0, t the logarithm of the perceived value,
and pt is the logarithm of the price. This class of strategies only depends on the mispricing
mt = pt t . Such a strategy takes a positive (long) position when the asset is underpriced;
if the asset becomes even more underpriced, the position either stays the same or gets larger.
Similarly, if the mispricing is positive it takes a negative (short) position.
If V is differentiable we can expand it in a Taylor series. To first-order the position can
be approximated as

xt+1 = c(t pt )

where c > 0 is a constant proportional to the trading capital. From Eq. (1) and (7), the
induced price dynamics in a market consisting only of this strategy and the market maker
are
rt+1 = rt + t + t+1 , pt+1 = pt + rt+1 (14)

where rt = pt pt1 , t = t t1 , and = c/. These dynamics are second-order.

This is evident from Eq. (14) since pt +1 depends on both pt and pt 1 The stability can
be determined by neglecting the noise terms and writing Eq. (14) in the form ut+1 = Aut
where ut = (rt , pt ). The eigenvalues of A are (1, ). Thus, when 1 the dynamics
are neutrally stable, which implies that the logarithm of the price, like the logarithm of the
value, follows a random walk. When > 1 the dynamics are unstable.
Simple value strategies induce negative first autocorrelations in the log-returns rt This is
easily seen by multiplying both sides of Eq. (14) by rt 1 , subtracting the mean, and taking
time averages. Assuming stationarity, this gives the recursion relation r ( ) = r ( 1).
Since r (0) = 1, this implies
r ( ) = () (15)
 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171 159

where = 0, 1, 2, . . . . Because > 0, the first autocorrelation is always negative. Since

the autocorrelation is determined by the linear part of V, this is true for any differentiable
value strategy in the form of Eq. (13).
This value strategy amplifies the price noise t but may or may not amplify the value
noise t .To see this, compute the variance of the log-returns by squaring Eq. (14) and taking
time averages. This gives
2 2 + 2
r2 = (16)
1 2
where 2 and 2 are the variances of t and t This amplifies the external noise, since for

any value of , r > . Similarly, if > (1/ 2) then r > .
This strategy by itself does not cause prices to track values. This is evident because
Eq. (14) shows no explicit dependence on price or value. The lack of cointegration can be
shown explicitly by substituting mt = pt t into Eq. (14), which gives

#mt+1 = #mt t + t

where #mt = mt mt1 . When < 1, #mt is stationary and mt is a random walk.
We have made several numerical simulations using various non-linear forms for V, and
we observe similar results. The intuitive reason for this behavior is that, while a trade en-
tering a position moves the price toward value, an exiting trade of the same size moves
it away from value by the same amount. Thus, while the negative autocorrelation in-
duced by simple value strategies might reduce the rate at which prices drift from value,
this is not sufficient for cointegration. The lack of cointegration can lead to problems
with unbounded positions, implying unbounded risk. This comes about because the mis-
pricing is unbounded, and the position is proportional to the mispricing. Thus, if this
is the only strategy present in the market the position is also unbounded. This prob-
lem disappears if another strategy is present in the market that cointegrates prices and
values.
So far we have assumed ongoing changes in value. It is perhaps even more surprising
that the price fails to converge even if the value changes once and then remains constant.
To see this, consider Eq. (14) with #1 = and #t = 0 for t > 1. Assume = 0, and
for convenience let 1 = 1 = 0 and #p1 = 0. Iterating a few steps by hand shows that
pt = ( 2 + 3 + ()t1 ). If < 1, in the limit t this converges to
p = /(1 + ). Thus, when < 1 the price initially moves toward the new value, but it
never reaches it; when > 1 the dynamics are unstable.

3.2.2. When do prices track values?

How can we solve the problem of making prices track values? One approach is to change
the price formation rule. As will be addressed in a future paper, this can be achieved
by including risk aversion for the market maker. An alternative that is explored here is
to investigate alternative value investing strategies. The order based value strategies dis-
cussed below fix the problem, but at the unacceptable cost of generating unbounded in-
ventories. The threshold value strategies introduced in Section 3.2.3 manage to achieve
both.
160 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171

3.2.3. Order-based value strategies

One way to make prices track values is to make the strategy depend on the order instead
of the position. A strategy of this type buys as long as the asset is underpriced, and sells as
long as it is overpriced. Under the simple value strategy of Section 3.2.2, if the mispricing
reaches a given level, the trader takes a position. If the mispricing holds that level, he keeps
the same position. For an order-based strategy, in contrast, if the asset is underpriced he will
buy, and if on the next time step it is still mispriced he will buy again, and continue doing
so as long as the asset remains mispriced. One can define an order-based value strategy of
the form
t+1 = (t , pt ) = W (t pt )
where as before W is an increasing function with W (0) = 0. If we again expand in a Taylors
series, then to leading order this becomes
t+1 = c(t pt )
Without presenting the details, let us simply state that it is possible to analyze the dynamics
of this strategy and show that the mispricing has a well-defined standard deviation. Prices
track values. The problem is that the position is not stationary, and the trader can accumulate
an unbounded inventory. This is not surprising, given that this strategy does not depend on
position.
The signal is to buy or sell as long as a mispricing persists, which means that typically
the position is not forced to go to zero, even when the mispricing goes to zero. This problem
occurs even in the presence of other strategies that cause cointegration of price and value.
Numerical experiments suggest that non-linear extensions have similar problems.8 Real
traders have risk constraints, which mean that position is of paramount concern. Strategies
that do not depend on the position are unrealistic.

3.2.4. State-dependent threshold value strategies

The analysis above poses the question of whether there exist strategies that cointegrate
prices and values and have bounded risk at the same time. This section introduces a class
of strategies with this property.
From the point of view of a practitioner, a concern with the simple position-based value
strategies of Section 3.2.1 is excessive transaction costs. Trades are made whenever the
mispricing changes. A common approach to ameliorate this problem and reduce trading
frequency is to use state dependent strategies, with a threshold for entering a position,
and another threshold for exiting it. Like the simpler value strategies studied earlier, such
strategies are based on the belief that the price will revert to the value. By only enter-
ing a position when the mispricing is large, and only exiting when it is small, the goal
is to trade only when the expected price movement is large enough to beat transaction
costs.
An example of such a strategy, which is both non-linear and state dependent, can be
constructed as follows: assume that a short position c is entered when the mispricing
8 The fundamentalist strategy used by Day and Huang (1990) is a non-linear order-based strategy. Had they

added a stochastic value process, they would have faced the problem of unbounded inventories.
 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171 161

Fig. 4. Schematic view of a non-linear, state-dependent value strategy. The trader enters a short position c when
the mispricing mt = pt Vt exceeds a threshold T, and holds it until the mispricing goes below . The reverse is
true for long positions.

Fig. 5. The non-linear state-dependent value strategy represented as a finite-state machine. From a zero position
a long-position c is entered when the mispricing m drops below the threshold T. This position is exited when
the mispricing exceeds a threshold . Similarly, a short position c is entered when the mispricing exceeds a
threshold T and exited when it drops below a threshold .

exceeds a threshold T and exited when it goes below a threshold . Similarly, a long position
c is entered when the mispricing drops below a threshold T and exited when it exceeds
. This is illustrated in Fig. 4. Since this strategy depends on its own position as well as
the mispricing, it can be thought of as a finite state machine, as shown in Fig. 5.
In general, different traders will choose different entry and exit thresholds. Let trader
i have entry threshold T (i) and exit threshold (i) For the simulations presented here we
will assume a uniform distribution of entry thresholds ranging from Tmin to Tmax , uniform
density of exit thresholds ranging from min to max , with a random pairing of entry and
exit thresholds. Parameter c is chosen so that c = a(T ), where a is a positive constant.9

9 This assignment is natural because traders managing more money (with larger c) incur larger transaction costs.

Traders with larger positions need larger mispricings to make a profit.

162 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171

Fig. 6. The induced price dynamics of a non-linear state-dependent value strategy with 1000 traders using different
thresholds. The log-price is shown as a solid curve and the log-value as a dashed curve. min = 0.5, max = 0,
T min = 0.5, T max = 6, N = 1000, a = 0.001, = 0.01, and = 0.01, and = 1.

There are several requirements that must be met for this to be a sensible value strategy.
The entry threshold should be positive and greater than the exit threshold, i.e. T > 0 and
T > . In contrast, there are plausible reasons to make either positive or negative. A
trader who is very conservative about transaction costs, and wants to be sure that the full
return has been extracted before the position is exited, will take < 0. However, others
might decide to exit their positions earlier, because they believe that once the price is near
the value there is little expected return remaining. We can simulate a mixture of the two
approaches by making min < 0 and max > 0. However, to be a sensible value strategy,
a trader would not exit a position at a mispricing that is further from zero than the entry
point. Parameter min should not be too negative, so we should have T < < T and
|min | Tmin .
The condition < 0 is a desirable property for cointegration. When this is true the
price changes induced by trading always have the opposite sign of the mispricing. This is
true both entering and exiting the position. A simulation with max = 0 and min < 0 is
shown in Fig. 6. Numerical tests clearly show that the price and value are cointegrated. The
cointegration is weak, however, in the sense that the mispricing can be large and keep the
same sign for many iterations.
Fig. 7 shows a simulation with the range of exit thresholds chosen so that min < 0 but
max > 0. For comparison with Fig. 6, all other parameters are the same. The price and
value are still cointegrated, but more weakly than before. This is apparent from the increased
amplitude of the mispricing. In addition, there is a tendency for the price to bounce as it
approaches the value. This is caused by the fact that when the mispricing approaches zero
some traders exit their positions, which pushes the price away from the value. The value
becomes a resistance level for the price (see, e.g. Edwards and Magee, 1992), and there
is a tendency for the mispricing to cross zero less frequently than it does when (i) < 0
for all i. Thus, we see that a value strategy can create patterns that could be exploited by
a technical strategy. Based on results from numerical experiments it appears that the price
 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171 163

Fig. 7. Price (solid curve) and value (dashed curve) vs. time for the non-linear state-dependent strategy of Fig. 5.
The parameters and random number seed are the same as Fig. 6, except that min = 0.5 and max = 0.5.

and value are cointegrated as long as min < 0. Necessary and sufficient conditions for
cointegration deserve further study.10

3.2.5. Heterogeneous values, representative agents, and excess volatility

So far we have assumed a single perceived value, but given the tendency of people to
disagree, in a more realistic setting there will be a spectrum of different values. We will show
that in this case, for strategies that are linear in the logarithm of value, the price dynamics
can be understood in terms of a single representative agent, whose perceived value is the
mean of the group. However, for non-linear strategies this is not true for there exists no
representative agent, and diverse perceptions of value can cause excess volatility.
(i)
Suppose there are N different traders perceiving value t , using a value strategy V (i) (t ,
(i) (i )
pt ) = c V (t , pt ),where c is the capital of each individual strategy. The dynamics are
N
1
(i) (i)
pt+1 = pt + x V (t , pt )

i=1

Providing the strategy is linear in the value the dynamics will be equivalent to those of a
single agent with the average perceived value and the combined capital. This is true if V
satisfies the property
N

(i)
c(i) V (t , pt ) = cV(t , pt )
i=1

10 Problems can occur in the simulations if the capital c = a(T ) for each strategy is not assigned reasonably.

If a is too small the traders may not provide enough restoring force for the mispricing; once all N traders are
committed to a long or short position, price and value cease to be cointegrated. If a is too big instabilities can
result because the price kick provided by a single trader creates oscillations between entry and exit. Nonetheless,
between these extremes there is a large parameter range with reasonable behavior.
164 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171

where
N
1
(i)
t = ci t
c
i=1

and c = ci For example, the linearized value strategy of Section 3.2.1 satisfies this
property. Thus, for strategies that depend linearly on the logarithm of value, the mean
is sufficient to completely determine the price dynamics, and the diversity of opinions is
unimportant. The market dynamics are those of a single representative agent.
The situation is quite different when the strategies depend non-linearly on the value.
To demonstrate how this leads to excess volatility, we will study the special case where
traders perceive different values, but these values change in tandem. This way we are
not introducing any additional noise to the value process by making it diverse, and any
amplification in volatility clearly comes from the dynamics rather than something that has
been added. The dynamics of the values can be modeled as a simple reference value process
t that follows Eq. (12), with a fixed random offset (i ) for each trader. The value perceived
by the ith trader at time t is
(i)
t = t + (i) (17)
In the following simulations the value offsets are assigned uniformly between min and
max , where min = max so that range is 2 max .
We will define the excess volatility as

r2
= (18)
2 + 2
i.e. as the ratio of the volatility of the log-returns to the volatility of the exogenous noise.
This measures the noise amplification. If > 1 the log-returns of prices are more volatile
than the fluctuations driving the price dynamics. Fig. 8 illustrates how the excess volatility
increases as the diversity of perceived values increases, using the threshold value strategy of
Section 3.2.4. The excess volatility also increases as the capital increases. This is caused by
additional trading due to disagreements about value. In the linear case, these would cancel
and leave no effect on the price, but because of the non-linearity of the strategy, this is not
the case. If the market is a machine whose purpose is to keep the price near the value, this
machine is noisy and inefficient.

3.3. Value investors and trend followers together

In this section, we investigate the dynamics in a more heterogeneous setting including

both non-linear trend following and value investing strategies. We use the threshold value
strategies described in Section 3.2.4, and use the trend strategy of Section 3.1, except that
we make it non-linear by adding entry and exit thresholds, just as for the value strategy
of Section 3.2.4. We make a qualitative comparison to annual prices and dividends for the
S&P index11 from 1889 to 1984, using the average dividend as a crude measure of value,
11 See Campbell and Shiller (1988). Both series are adjusted for inflation.
 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171 165

Fig. 8. Excess volatility as the range of perceived values increases while the capital is fixed at 0.035 (see Eq. (18)).
The other parameters are the same as those in Fig. 6.

and simulating the price dynamics on a daily timescale. As a proxy for daily value data we
linearly interpolate the annual logarithm of the dividends, creating 250 surrogate trading
days for each year of data. These provide the reference value process t in Eq. (17).
The parameters for the simulation are given in Table 1. There were two main criteria
for choosing parameters: first, we wanted to match the empirical fact that the correlation
of the log-returns is close to zero. This was done by matching the population of trend
followers and value investors, so that the positive short-term autocorrelation induced by the
trend followers is canceled by the negative short-term autocorrelation of the value investors.
Thus, the common parameters for trend followers and value investors are the same. Second,
we wanted to match the volatility of prices with the real data. This is done primarily by
the choice of a and N in relation to , and secondarily by the choice of min and max .

Table 1
Parameters for the simulation with trend followers and value investors in Fig. 10
Description of parameter Symbol Value

Number of agents Nvalue , Ntrend 1200

Minimum threshold for entering positions Tmin
value
, Tmin
trend
0.2
Maximum threshold for entering positions value , T trend
Tmax max 4
Minimum threshold for exiting positions min , min
value trend
0.2
Maximum threshold for exiting positions max
value , trend
max 0
Scale parameter for capital assignment value , trend 2.5 103
Minimum offset for log of perceived value min 2
Maximum offset for log of perceived value max 2
Minimum time delay for trend followers min 1
Maximum time delay for trend followers max 100
Noise driving price formation process 0.35
Liquidity 1
166 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171

Fig. 9. Inflation-adjusted annual prices (solid curve) and dividends for the S&P index of American stock prices.

Finally, we chose what we thought was a plausible timescale for trend following uniformly
distributed from 1 to 100 days.
The real series of American prices and values are shown in Fig. 9 and the simulation
results are shown in Fig. 10. There is a qualitative correspondence. In both series the
price fluctuates around value, and mispricings persist for periods that are sometimes mea-
sured in decades. However, at this point no attempt has been made to make forecasts,
which is not trivial for this kind of model. The point of the above simulation is just to

Fig. 10. A simulation with value investors and trend followers. The linearly interpolated dividend series from
Fig. 9 provides the reference value process. Prices are averaged to simulate reduction to annual data. There was
some adjustment of parameters, as described in the text, but no attempt was made to match initial conditions. The
oscillation of prices around values is qualitatively similar to Fig. 9.
 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171 167

Fig. 11. Smoothed trading volume of value investors (solid curve) and trend followers (dashed curve). The two
groups become active at different times; when the value investors dominate the log-returns have a negative au-
tocorrelation, and when the trend followers dominate there is a positive autocorrelation. Even though there is no
linear temporal structure, there is strong non-linear structure. Parameters are as described in Table 1; this is only
a short portion of the total simulation.

demonstrate how a combination of trend and value investors results in oscillations in the
mispricing.
Because of the choice of parameters there is no short-term linear autocorrelation structure
in this price series. There is plenty of non-linear structure, however, as illustrated in Fig. 11,
which shows the smoothed volume12 of value investors and trend followers as a function of
time. The two groups of traders become active at different times, simply because the condi-
tions that activate their trading are intermittent and unsynchronized. This is true even though
the capital of both groups is fixed. Since the trend followers induce positive autocorrelations
and the value investors negative autocorrelations, there is predictable non-linear structure
for a trader who understands the underlying dynamics well enough to predict which group
will become active. Without knowledge of the underlying generating process, however, it
is difficult to find such a forecasting model directly from the timeseries.
Statistical analysis displays many of the characteristic properties of real financial time-
series, as illustrated in Fig. 12. The log-returns are more long-tailed than those of a normal
distribution, i.e. there is a higher density of values at the extremes and in the center with a
deficit
 in between.
 This also evident in the size of the fourth moment. The excess kurtosis
k = (rt rt )4 /r4 3 is roughly k 9, in contrast to k = 0 for a normal distribution.
The histogram of volumes is peaked near zero with a heavy positive skew. The volume
and volatility both have strong positive autocorrelations. The intensity of the long-tails and
correlations vary as the parameters are changed or strategies are altered. However, the basic
properties of long tails and autocorrelated volume and volatility are robust as long as trend
followers are included.
12 The smoothed volume is computed as Vt = Vt1 + (1 )Vt , where Vt is the volume and = 0.9.
168 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171

Fig. 12. An illustration that an ecology of threshold based value investors and trend followers shows statistical
properties that are typical of real financial time series. The upper left panel is a qq plot, giving the ratio of
the quantiles of the cumulative probability distribution for the log-returns to those of a normal distribution. If the
distribution were normal this would be a straight line, but since it is fat tailed the slope is flatter in the middle and
steeper at the extremes. The upper right panel shows a histogram of the volume. It is heavily positively skewed.
The lower left panel shows the autocorrelation of the volume, and the lower right panel shows the autocorrelation
of the volatility. These vary based on parameters, but fat tails and temporal autocorrelation of volume and volatility
are typical.

Clustered volatility has now been seen in many different agent-based models.13 It seems
there are many ways to do produce this behavior. The mechanism in this case is due to
positive feedback: large price fluctuations cause large trading volume, which causes large
price fluctuations, and so on, generating volatility bursts. Even without any autocorrelations

13 Some examples include Brock and LeBaron (1996), Levy et al. (1996), Takayasu et al. (1997), Arthur et al.

(1997), LeBaron et al. (1999), Caldarelli et al. (1997), Brock and Hommes (19971999), Lux (1997, 1998), Lux
and Marchesi (1999), Youssefmir et al. (1998), Bouchaud and Cont (1998), Gaunersdorfer and Hommes (1999) and
Iori (1999). Fat tails with realistic tail exponents have been observed by Lux and Marchesi (1999) in simulations
of value investors and trend-followers based on the log-linear price formation rule; Stauffer and Sornette (1999)
have predicted realistic exponents using Eq. (8) with randomly varying liquidity.
 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171 169

in prices themselves, the non-linearly driven variations in the trading activity of value and
trend strategies can cause autocorrelations in volatility. Several authors, including Lux
(1997, 1998), Lux and Marchesi (1999), and Brock and Hommes (19971999) have sug-
gested that fluctuating volatility is driven by changes in the population of trend followers.
For real markets, this may be problematic: real agents may not change strategies this fast.
The feedback hypothesis offered here does not require agents to change strategies. However,
it is not clear whether the resulting volatility correlations are strong enough to match those
observed in real data. More work is needed to resolve this question.
The few results presented here fail to do justice to the richness of the trend follower/value
investor dynamics. We have observed many interesting effects. For example, the presence of
trend followers increases the frequency of oscillations in mispricing. The mechanism seems
to be more or less as follows: if a substantial mispricing develops by chance, value investors
become active. Their trading shrinks the mispricing, with a corresponding change in price.
This causes trend followers to become active; first the short-term trend followers enter, and
then successively longer-term trend followers enter, sustaining the trend and causing the
mispricing to cross through zero. This continues until the mispricing becomes large, but
with the opposite sign, and the process repeats itself. As a result, the oscillations in the
mispricing are faster than they would be without the trend followers. This mechanism is a
less regular version of that postulated by Chiarella (1992).

4. Concluding remarks

These results illustrate how commonly used trading strategies affect prices. Trend follow-
ing strategies act as signal filters, amplifying high frequency noise and inducing short-term
positive autocorrelations. Value investing strategies act as signal transducers, incorporat-
ing information about value into prices, and inducing negative short-term autocorrelations.
The fact that prices in real markets have very small autocorrelations suggests that value
investors cannot be the only group presentthere must be other strategies in use, such as
trend following, that cancel their negative autocorrelations.
Nonlinear value investing strategies can amplify noise in a heterogeneous setting where
there are diverse views concerning value. Trend following strategies strongly amplify low
frequency noise, so that when the two groups are combined the result is excess volatility.
When value investing and trend following strategies are combined, by adjusting their relative
populations, the short-term autocorrelations can be made to cancel, so that in a long time
average there is very little linear structure. However, because each style of trading is activated
differently, there may be bursts of trading by either group, even without agents defecting
from one group to the other. The feedback effects studied here give rise to clustered volatility;
unlike explanations that rely on oscillations in the populations of different groups of traders,
this explanation is plausible even on fairly rapid timescales. However, this effect is probably
too weak to explain the clustered volatility observed in real markets.
A key element missing from the price formation mechanism studied here is risk aversion
by the market maker. This has several profound effects on price dynamics. First, it serves
to reduce deviations from market clearing, and makes prices track values more closely.
However, the fact that the market maker has to off-load risk also makes prices positively
170 J.D. Farmer, S. Joshi / J. of Economic Behavior & Org. 49 (2002) 149171

correlated. This can be exploited by trend followers, and provides one possible explanation
for the persistence of trend followers. In the future paper, we will present some results that
include market maker risk aversion, and which also study the profitability and reinvestment
dynamics of different groups of agents.

Acknowledgements

We would like to thank Paul Melby for contributing Fig. 3, and John Geanakoplos for
helpful discussions. We also thank the McKinsey Corporation for their generous support.

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