Market force , ecology , and evolution 1

In financial markets an excess of buying tends to drive prices up, and an excess of selling tends to drive them down. This is called market impact. Based on a simplified model for market making it is possible to derive a unique functional form for market impact. This can be used to formulate a non-equilibrium theory for price formation. Commonly used trading strategies such as value investing and trend following induce characteristic dynamics in the price. Although there is a tendency for self-fulfilling prophesies, this is not always the case; in particular, many value investing strategies fail to make prices reflect values. When there is a diversity of perceived values, nonlinear strategies give rise to excess volatility. Many market phenomena such as trends and temporal correlations in volume and volatility have simple explanations. The theory is both simple and experimentally testable.