Profitable mean reversion after large price drops

7/28/2019 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

[email protected]

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:

6

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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strategy II

Close-Close holding period, small caps:


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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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Thank you for your attention

Q & A

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Profitable mean reversion after large price drops