Optimistic & Pessimistic Trading in Financial Markets

There is an abundant literature in finance on overconfidence, however there exists a different psychological trait well known to financial practitioners and psychologists [see Hilton at al. (2004)] which is optimism. This trait has received little attention. Our paper analyses the consequences of optimism and pessimism on financial markets. We develop a general model of optimism/pessimism where M unrealistic informed traders and N realistic informed traders trade a risky asset with a competitive market maker. Unrealistic traders can (i) misperceive the expected returns of the risky asset (scenario 1) or (ii) in addition to the previous can make a judgmental error on both the volatility of the asset returns and the variance of the noise in his/her private signal (scenario 2). We show, in scenario 1, that optimistic traders purchase more or sell smaller quantities whereas pessimistic traders sell more or purchase smaller quantities than if they were realistic. As market makers correctly anticipate that, we obtain that (i) the price level and the market depth are equal to the ones predicted by a standard model a la Kyle (1985) with M + N realistic traders and (ii) unrealistic and realistic traders obtain the same expected profit. In scenario 2, we show that (i) unrealistic traders may earn negative, higher or lower expected profit than realistic traders, (ii) the expected profit of the realistic and the unrealistic trader is a non-monotonic function of the two degrees of error, and (iii) market depth is also a non-monotonic function of the error on the volatility of asset as well as the error on the variance of the noise. All of the above results are derived when market makers are realistic. We show that the results are not altered if market makers are themselves optimistic or pessimistic. The expected profit for the unrealistic market makers can either be positive or negative.