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 Rudy

Corresponding author and presenter : Jozef Rudy J.Rudy@2009.ljmu.ac.uk Liverpool JMU, TATRA Asset Management

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), where assumption 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
Cliff et al (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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Data used
Constituents of S&P 500, S&P 400 and S&P 600

Period:
Data source: Bloomberg
Trade prices used

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

Costs of trading
Trading costs one-way: 0.05%
Transaction costs: 0.05% Bid-ask spread: 0%

Net return calculation:

Rett ln( PX t / PX t 1 ) TC

Results
Portfolio of equal % holding of entire index Day (Open-Close) and Night (Close-Open) Returns no real difference and no edge

Results by deciles small caps

Version 1

Version 2

Results by deciles mid caps

Version 1

Version 2

Results by deciles big caps

Version 1

Version 2

Results first decile Year over Year

Close Close Version 1

Version 2

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 the viability even after the inclusion of a bid-ask bounce

Results Excess over Close-Close strategy II

Close-Close holding period, small caps:

Results Excess over Close-Close strategy III

Excess information ratios first decile:

Results Significant alpha in FamaFrench framework

Fama-French:
r s t r f t 1 (r m t r f t ) 2 SMBt 3 HMLt t
1 1 SMB (Small _ Value Small _ Neutral Small _ Growth) ( Big _ Value Big _ Neutral Big _ Growth) 3 3 1 1 HML ( Small _ Value Big _ Value) ( Small _ Growth Big _ Growth) 2 2

S&P 500 Universe:

Conclusions
Profitable strategy achieved by increasing the sampling frequency

Significant alpha

References

Chan, E. (2009) Quantitative Trading: How to Build Your Own Algorithmic Trading Business, 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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