Speculative Trading, Prospect Theory and Transaction Costs

TL;DR

This paper models a speculative agent's optimal trading strategy under Prospect Theory preferences considering transaction costs, revealing complex interactions between behavioral biases and market frictions that influence trading patterns.

Contribution

It provides a complete characterization of the optimal trading strategies for a Prospect Theory-based agent in the presence of transaction costs, highlighting novel behavioral-market interactions.

Findings

Optimal strategies include 'buy and hold', 'buy low sell high', 'buy high sell higher', or no trading.

Market entry fees can paradoxically increase trading activity due to behavioral effects.

Behavioral preferences and transaction costs jointly shape trading patterns in unexpected ways.

Abstract

A speculative agent with Prospect Theory preference chooses the optimal time to purchase and then to sell an indivisible risky asset to maximize the expected utility of the round-trip profit net of transaction costs. The optimization problem is formulated as a sequential optimal stopping problem and we provide a complete characterization of the solution. Depending on the preference and market parameters, the optimal strategy can be "buy and hold", "buy low sell high", "buy high sell higher" or "no trading". Behavioral preference and market friction interact in a subtle way which yields surprising implications on the agent's trading patterns. For example, increasing the market entry fee does not necessarily curb speculative trading, but instead it may induce a higher reference point under which the agent becomes more risk-seeking and in turn is more likely to trade.