Profitable mean reversion after large price drops
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Profitable mean reversion after large price drops:
A story of day and night in the S&P 500, 400
MidCap and 600 SmallCap Indices
May 2011
Authors:Christian L. Dunis
Jason Laws
Jozef RudyCorresponding author and presenter :
Jozef Rudy
Liverpool JMU, TATRA Asset Management
mailto:[email protected]:[email protected] -
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Outline
Motivation
Data used
Methodology 2 versions of the strategy
Results
Conclusions
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Motivation
Contrarian profits explained by overreaction hypothesis (Lo and MacKinlay, 1990), whereassumption of negative autocorrelation is very common (Locke and Gupta, 2009)
Contrarian profits exclusively after large price falls (Choi and Jayaraman, 2009), no condition of
autocorrelation necessary
Recent decreasing performance of contrarian strategies (Khandani and Lo, 2007)
According to Fama (1997, p. 6) most anomalies are shaky and tend to disappear when reasonable
alternative approaches are used to measure them
Majority of trading ideas well-known across Wall Street. A practical implementation and
parameters make every strategy unique (Chan, 2009)
Unique idea: to increase sampling frequency from Close-Close to Close-Open-Close: non-standard
sampling frequency
Cliffetal (2008, p. 2) affirm that the impact of the periodical market closes on the first moment of
stock returns is still not fully understood.
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Methodology I
Strategy (Version 1):
Buy n worst shares during night, hold during day
Strategy (Version 2):
Buy n worst shares during day, hold during night
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Costs of trading
Trading costs one-way: 0.05% Transaction costs: 0.05%
Bid-ask spread: 0%
Net return calculation:
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1ln( / )
t tt X XRet P P TC
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Results
Portfolio of equal % holding of entire index
Day (Open-Close) and Night (Close-Open)
Returnsno real difference and no edge
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Results by deciles small caps
Version 1
Version 2
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Results by deciles mid caps
Version 1
Version 2
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Results by deciles big caps
Version 1
Version 2
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Results first decile Year over Year
Close Close Version 1
Version 2
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Results Excess over Close-Close
strategy I
According to Park (1995), the profitability of a mean
reversion strategy disappears (goes to 0 no
profitable edge) once the average bid-ask price is
used instead of a closing price.
Thus, if we can prove, that our strategys results are
well in excess of Close-Close strategy, we show theviability even after the inclusion of a bid-ask bounce
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Results Excess over Close-Close
strategy II
Close-Close holding period, small caps:
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Results Excess over Close-Close
strategy III
Excess information ratios first decile:
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Results Significant alpha in Fama-
French framework
Fama-French:
S&P 500 Universe:
1 2 3( )s f m f
t t t t t t t r r r r SMB HML
1 1( _ _ _ ) ( _ _ _ )
3 3SMB Small Value Small Neutral Small Growth Big Value Big Neutral Big Growth
1 1( _ _ ) ( _ _ )
2 2HML Small Value Big Value Small Growth Big Growth
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Conclusions
Profitable strategy achieved by increasing
the sampling frequency
Significant alpha
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References
Chan, E. (2009) Quantitative Trading: How to Build Your Own Algorithmic TradingBusiness, John Wiley & Sons, Inc., New Jersey.
Choi, H. S. and Jayaraman, N. (2009) Is Reversal of Large Stock-Price Declines
Caused by Overreaction or Information Asymmetry: Evidence from Stock and
Option Markets.Journal of Futures Markets. 29, 4, 348-376.
Cliff, M. T., Cooper, M. J. and Gulen, H. (2008) Return Differences between Trading
and Non-Trading Hours: Like Night and Day. SSRN eLibrary,http://ssrn.com/paper=1004081
Fama, E. F. and French, K. R. (1993) Common Risk Factors in the Returns on Stocks
and Bonds.Journal of Financial Economics. 33, 1, 3-56.
Khandani, A. E. and Lo, A. W. (2007) What Happened to the Quants in August
2007?Journal of Investment Management, 5,4, 5-54. Lo, A. W. and Mackinlay, A. C. (1990) When Are Contrarian Profits Due to Stock
Market Overreaction? The Review of Financial Studies, 3,2, 175-205.
Locke, S. and Gupta, K. (2009) Applicability of Contrarian Strategy in the Bombay
Stock Exchange.Journal of Emerging Market Finance, 8,2, 165-189.
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http://ssrn.com/paper=1004081http://ssrn.com/paper=1004081http://ssrn.com/paper=1004081http://ssrn.com/paper=1004081http://ssrn.com/paper=1004081http://ssrn.com/paper=1004081http://ssrn.com/paper=1004081 -
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Thank you for your attention
Q & A
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