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Trading in Crowded Markets

Author

Listed:
  • Stepan Gorban

    (New Economic School)

  • Anna A. Obizhaeva

    (New Economic School)

  • Yajun Wang

    (University of Maryland)

Abstract

We study crowded markets using a symmetric continuous-time model with strategic informed traders. We model crowdedness by assuming that traders may have incorrect beliefs about the number of smart traders in the market and the correlation among private signals, which distort their inference, trading strategies, and market prices. If traders underestimate the crowdedness, then markets are more liquid, both permanent and temporary market depths tend to be higher, traders take larger positions and trade more on short-run profit opportunities. In contrast, if traders overestimate the crowdedness, then traders believe markets to be less liquid, they are more cautious in both trading on their information and supplying liquidity to others; fears of crowded markets may also lead to "illusion of liquidity" so that the actual endogenous market depth is even lower than what traders believe it to be. Crowdedness makes markets fragile, because flash crashes, triggered whenever some traders liquidate large positions at fire-sale rates, tend to be more pronounced.

Suggested Citation

  • Stepan Gorban & Anna A. Obizhaeva & Yajun Wang, 2020. "Trading in Crowded Markets," Working Papers w0275, New Economic School (NES).
    • Handle: RePEc:abo:neswpt:w0275
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    File URL: https://www.nes.ru/files/Preprints-resh/WP275.pdf
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    References listed on IDEAS

    as
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    5. Kondor, Péter & Zawadowski, Adam, 2019. "Learning in crowded markets," Journal of Economic Theory, Elsevier, vol. 184(C).
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    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    Asset Pricing; Market Liquidity; Market Microstructure; Crowding; Price Impact; Strategic Trading; Transaction Costs;
    All these keywords.

    JEL classification:

    • B41 - Schools of Economic Thought and Methodology - - Economic Methodology - - - Economic Methodology
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • G02 - Financial Economics - - General - - - Behavioral Finance: Underlying Principles
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading

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