Noise Trading and Illusory Correlations in US Equity Markets

Abstract

This paper provides evidence that “illusory correlations”—a well-documented source of cognitive bias—lead some agents to be imperfectly rational noise traders. We focus on the head-and-shoulders chart pattern, considered by technical analysts to provide one of the most reliable trading signals. Our findings indicate that the pattern is associated with a substantial rise in trading volume even though it does not profitably predict directional movements. We further substantiate the connection between head-and-shoulders trading and imperfectly rational noise trading by showing that the pattern is associated with lower bid-ask spreads.