Chasing trends at the micro-level: The effect of technical trading on order book dynamics

Technical traders attempt to exploit trends in market prices and the order flow. Despite this little is known about how these traders behave in a micro-structure context. We consider a model of an order book based financial market. The market contains two groups: informed traders and technical traders. A numerical technique is used to identify a Markov perfect equilibrium of the trading game and so determine the optimal strategies. We find that technical trading rules are profitable and allow traders to increase their returns. The effect of technical traders on the market, however, is ambiguous. They decrease volatility and pricing errors but also increase trading costs despite primarily acting as liquidity suppliers.