Optimal trading and competition with information in the price impact model

Longjie Xu and Yufeng Shi

Quantitative Finance, 2024, vol. 24, issue 6, 811-825

Abstract: Information drives trading and hence affects price dynamics. We study how an informed trader optimally trades, how multiple traders compete with each other, and how their competition affects price dynamics as well as their inventories in the linear price impact model framework. We formulate the informed trading problem as a stochastic optimal control problem and a stochastic differential game in different cases. By virtue of different methods, problems are solved explicitly in all cases. In the case of a single trader, the risk-averse informed trader trades less in the beginning and then speeds up to reduce exposure to the volatility of dynamic information. In addition, the risk-averse trader reveals information more slowly and thus contributes less to price efficiency. When multiple risk-neutral traders compete with information, regardless of the competition structure, they tend to trade more rapidly in the early stage to fill orders at a good price. Competition and the presence of a leader help promote price efficiency, and competition also leads to the empirically observed mean-reverting behavior of price dynamics and order flows. Furthermore, among risk-averse informed traders, inventory management triggers predatory trading and active information leakage during informed trading, and the positions of traders with the same level of risk aversion tend to be identical and mean-reverting to zero under multiple rounds of competition.

Date: 2024
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DOI: 10.1080/14697688.2024.2357729

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