Noise Trading and Illusory Correlations in US Equity Markets*

Abstract

Abstract. This paper provides evidence that "illusory correlations," a well-documented source of cognitive bias, leads some agents to be imperfectly rational noise traders. We identify illusory correlations by focusing on the head-and-shoulders chart pattern. Though this is considered one of the most reliable technical trading signals, our evidence indicates that the signal does not profitably predict directional movements as claimed. We connect this illusory correlation to noise trading by showing that the pattern is associated with a significant rise in trading volume and a substantial reduction in bid-ask spreads.JEL Classification: G12, G14

Trading on Noise: Moving Average Trading Heuristics and Private Investors

“…We view this finding as compelling evidence that retail technical traders act as noise traders in the sense of Black (1986, p. 531): "Perhaps they [i.e., the investors-authors' note] think the noise they are trading on is information." In that regard, our study extends Bender et al (2013), who also find an increased trading volume without significant abnormal returns on and subsequent to days with trading signals on an aggregate market level.…”

“…These results hold after controlling for an extensive set of predictors of trading volume and they are consistent with recent literature. For instance, Bender et al (2013) report an average abnormal trading activity of approximately 60% on days with signals from head-and-shoulder chart patterns. Etheber (2014) examines moving average trading heuristics on the German stock market and documents an ab-4 See, for example, leading German newspapers like Die Zeit (Oberhuber, 2013) and Frankfurter Allgemeine Zeitung (Mohr, 2015) or well-known German magazines (Focus Money, 2013). normal trading activity in individual stocks of approximately 25-55% on buy signal days (15-25% on sell signal days).…”

Neoclassical finance, behavioral finance and noise traders: A review and assessment of the literature

“…Technical analysts use charts to discern patterns that help them make their investment decisions-one of these patterns is the head-and-shoulders formation. Bender, Osler and Simon (2013) use the head-andshoulders pattern to identify "illusory correlation" in financial markets. They provide evidence indicating that technical analysis is alive and well, reporting that trading volume is over 60 per cent higher than normal around the time when head-and-shoulders patterns are observed.…”

“…For instance, Black (1986) describes noise traders as investors who do not trade on the basis of information whilst Bender, Osler and Simon (2013) find evidence indicating that noise traders use technical analysis in the form of the "head-and-shoulders" chart pattern. Lee et al (1991) demonstrate that noise traders are active and that they do influence market prices.…”

Market Efficiency in Asian and Australasian Stock Markets: A Fresh Look at the Evidence

“…On the other hand, there are arguments that these observations against the EMH are in fact spurious. For example, Bender et al (2013) argue that technical analysis rules might reflect imperfectly rational noise trading and stock chart patterns might just be "illusory correlations". Zhang and Jacobsen (2013), find that monthly seasonal effects may not be real, as they could be subject to data snooping bias, noise, and sample selection bias.…”