Quantopian & Quantpedia Trading Strategy Series: Reversal during Earnings Announcements Friday, 9 September, 2016

We are really excited that Quantopian & Quantpedia Trading Strategy Series continues with a second article focused on Reversal Effect during Earning Announcements (Strategy #307).

Click on a "View Notebook" button to read a complete analysis:

Eric C. So of MIT and Sean Wang of UNC in their paper News-Driven Return Reversals: Liquidity Provision Ahead of Earnings Announcements show that abnormal short-term returns reversals take place during the period immediately surrounding earnings announcements. They surmise that this reversal results from market makers' response to a temporary demand imbalance, as they temporarily shift the stock's price to ride out the imbalance.

Quantopian's analysis by Nathan Wolfe confirms initial findings of So & Wang original academic paper. Nathan finds evidence of returns reversal during earnings announcements; while the paper tested using data from 1996 to 2011, Nathan used data from 2007 to 2016. The average reversal among all stocks in his data is 0.449%, compared to a result of 1.448% in the paper. He found that we can reasonably increase the reversal to 0.6% by selecting firms based on a minimum average dollar volume percentile, or based on a minimum market cap.

In order to ensure liquidity, the strategy limits its universe to those stocks in the Q500US which are at or above the 95th percentile of average dollar volume among all equities on the platform. One day before each earnings announcement for each company, the algorithm determines the stock's 5-day returns quintile among all equities. Since reversal is expected, the algorithm goes short on the stock if it's in the highest quintile and long if it's in the lowest quintile. Positions are usually held for one day.

The final Quantopian OOS equity curve looks again really good:

Strategy's performance

Perfect work from Nathan!

You may also check first article in this series if you liked the current one. We are again looking forward to the next one ...

Effect of Maturity Structure of Roll Yields in Commodity Futures Strategies Sunday, 4 September, 2016

Related to multiple commodity futures long/short strategies, mainly to term-structure based strategies (like #22 - Term Structure Effect in Commodities) ...

Authors: Ghoddusi

Title: Maturity Structure of Commodity Roll Strategies: Evidence from the Energy Futures

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2820228


We investigate the maturity-structure of roll strategy returns in the energy futures markets. Our innovation is to report and analyze the risk/return profile, the Sharpe ratio, and the asset pricing loadings of rollover strategies based on futures contracts of the same underlying commodity but with maturities between two and 12 months. We find that a conditional rollover strategy, which takes a long position in backwardation and a short position in contango, delivers the highest Sharpe ratio for all commodities. While we don't observe a significant difference in terms of asset pricing beta for different roll positions, the Sharpe ratio tends to be higher for contracts with a shorter time to maturity. We also report some distinct patterns of maturity-structure across energy commodities. Findings of the paper have implications for managing commodity-based investments.

Notable quotations from the academic research paper:

"The rollover (or roll) strategy includes entering a futures contract with a given time-to-maturity, holding the futures contracts for a certain time period (typically for one month), and then closing the position to realize the return generated by changes in the price of the underlying futures contract. The investor then opens a new futures contract position (with the same time-to-maturity as before) and repeats the strategy.

The main contribution of the current paper is to examine the performance of rollover strategies de ned on futures contracts with di fferent time-to-maturity or what we call maturity structure of roll yields. By allowing the investment strategy to enter and exit futures contracts beyond the front month and to hold the contract for a time shorter than its maturity, we construct the maturity structure and discuss its properties for the ve selected commodities.

We document a monotonic relationship between the length of futures contracts and three key measures: the average return, the volatility of returns, and the Sharpe ratio. The results are robust for all commodities. The average return and volatility curves all decline with the length of the futures contract. However, the slope of the Sharpe ratio curve depends on the investment strategy chosen. For unconditional investment strategies the slope is positive, meaning that the further into the future the maturity date of the futures contracts, the higher is the Sharpe ratio. The relationship gets reversed when the investment position is conditioned on the slope of the forward curve."

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Equity Anomalies Persist in International Markets Monday, 22 August, 2016

A very important academic paper suggests that investors should trade global equity markets if they want to pursue equity long-short strategy ... Related to multiple equity long/short strategies...

Authors: Jacobs, Muller

Title: Anomalies Across the Globe: Once Public, No Longer Existent?

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2816490


Motivated by McLean and Pontiff (2016), we study the pre- and post-publication return predictability of 138 anomalies in 39 stock markets. Based on more than a million anomaly country-months, we find that the United States is the only country with a statistically significant and economically meaningful post-publication decline in long/short returns. The surprisingly large differences between the U.S. and international markets cannot be fully explained with general time effects or differences in limits to arbitrage, in-sample anomaly profitability, data availability, or local risk factor exposure. Our results have implications for the recent literature on arbitrage trading, data mining, and market segmentation.

Notable quotations from the academic research paper:

"In this study, we explore post-publication effects of 138 anomalies in the U.S. and 38 international stock markets.

International stock markets are economically important. During our sample period from January 1981 to December 2013, non-U.S. countries account on average for about 59% of the world market capitalization and for 72% of global GDP. Existing asset pricing tests in general tend to focus on the U.S. stock market. International out-of-sample tests may help to provide novel insights into the price discovery process and to enrich or challenge our understanding of price formation.

Indeed, we fi nd surprisingly large differences between post-publication effects in the U.S. stock market and international markets. Among the 39 stock markets that we study, only the U.S. market shows a signifi cant post-publication decline in long/short returns. In contrast, the same econometric framework suggests that none of the 38 international markets yields a signi ficant post-publication decline in anomaly returns. Overall, we do not find reliable evidence for an arbitrage-driven decrease in anomaly pro tability in international markets.

We explore several possible mechanisms behind the surprisingly large differences between the return dynamics in the U.S. and international markets, but are unable to fully explain the results. Our findings are consistent with the idea that sophisticated investors learn about mispricing from academic studies, but then focus mainly on the U.S. market. In addition to these event-time publication effects, there is a general negative calendar-time trend in anomaly returns in the U.S. stock market, but not in other major stock markets.

Averaged over our whole sample period, long/short anomaly returns in (various subsets of) international markets turn out to be similar in magnitude as the estimates for the U.S. market. This unconditional view suggests that many anomalies tend to be a global phenomenon and thus are unlikely to be mainly driven by data mining.

Our findings add to the large literature on international stock market segmentation. We contribute to this debate by providing evidence for seemingly strong geographic stock market segmentation which appears to have significant effects on the formation of prices. From a practical point of view, these findings may offer quantitative arbitrageurs insights into ways to optimize their investment process. A thorough analysis of geographic differences in capital invested in quantitative arbitrage strategies is needed.


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Two Recent Papers Related to FX Carry Strategy Monday, 15 August, 2016

Two academic papers related to:

#5 - FX Carry Trade


1. Volatility and liquidity risk factors explain Carry strategy:

Authors: Shehadeh, Li, Moore

Title: The Forward Premium Bias, Carry Trade Return and the Risks of Volatility and Liquidity

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2789141


In this paper, we analyse the relationship between the currency carry return and volatility and liquidity risk factors. We find that both categories of risk factors are relevant to understanding and explaining carry return, with an outperformance for volatility ones especially the global FX volatility risk factor. Consistent with the poor performance of currency carry trades during high FX volatility regime, we also show that the well-established negative slope coefficient in the Fama regression tends to be more positive and even above unity in times of high FX volatility. The paper, overall, contributes to the risk-based solution of the forward premium bias puzzle.


2. FX variance and negative skewness risk factors explain Carry strategy:

Authors: Broll

Title: The Carry Trade and Implied Moment Risk

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2775663


The carry trade is a zero net investment strategy that borrows in low yielding currencies and subsequently invests in high yielding currencies. It has been identified as highly profitable FX strategy delivering significantly excess returns with high Sharpe ratios. This paper shows that these excess returns are especially compensation for bearing FX variance and negative skewness risk. Additionally, factor risks that affect foreign money changes, foreign inflation changes, as well as changes to a newly developed Carry Trade Activity Index and the VIX index, as a proxy for global risk aversion, make up the carry trade risk anatomy. These findings are not exclusively important for carry traders, but also contribute to the understanding of currency risk in the cross-section. This is directly linked to asset pricing tests from Lustig et al. (2011), which have shown that currency baskets sorted on their interest rate differentials are all exposed to carry trade returns as a risk factor. Furthermore, this paper finds evidence that a decreased level of funding liquidity potentially leads to carry trade unwindings, controlling for equity and FX implied variance and skewness effects, which supports the theoretical model of liquidity spirals developed by Brunnermeier and Pedersen (2009).



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Using Fundamentals to Improve Pairs Trading Strategy Saturday, 6 August, 2016

A related paper has been added to:

#12 - Pairs Trading with Stocks

Authors: Mazo, Lafuente, Gimeno

Title: Pairs Trading Strategy and Idiosyncratic Risk. Evidence in Spain and Europe.

Link: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2807956


Pairs trading strategy’s return depends on the divergence/convergence movements of a selected pair of stocks’ prices. However, if the stable long term relationship of the stocks changes, price will not converge and the trade opened after divergence will close with losses. We propose a new model that, including companies’ fundamental variables that measure idiosyncratic factors, anticipates the changes in this relationship and rejects those trades triggered by a divergence produced by fundamental changes in one of the companies. The model is tested on European stocks and the results obtained outperform those of the base distance model.

Notable quotations from the academic research paper:

"The purpose of this research is to propose a pairs trading model that increases return compared to the model of distance (Gatev et al., 2006). We will introduce some rules in the model, based on fundamental variables, so that persistent divergence in the relationship of the prices of the two selected stocks could be foreseen. When we analyze the results of the distance method in previous works, we found that the number of trades with losses was high and the increase of such trades was one of the reasons of the decline of pairs trading strategy return.

Depending on the reason why a divergence on a stock price pair leads to execute the trade, it will be more or less likely that the stock price pair will convergence again. Thus, if the stock price pair divergence is due to irrational investors that leads to liquidity tensions, later convergence is likely to happen. However, if the reason of such divergence is new information about the companies’ fundamentals, divergence is likely to remain and there will be another equivalence relation between both stocks (Andrade et al., 2005). This is the starting point of this paper: beginning from the basic model of distance, we test which variables related to companies’ performance could anticipated if divergence is temporal or permanent.

The variables we use in the model are selected from analysts’ consensus. The data are obtained from FactSet, a financial information provider. The reason to choose the values provided by analysts’ consensus is that they consider the implicit information in analysts’ recommendations that follow a certain stock.
The variables considered in the model are:
a) Earnings per Share in the next 12 months. (EPS).
b) Book Value per Share (BVPS).
c) Target Price (TP).
d) Recommendation.
e) Knowledge of the firm, measured as the number of estimations of each stock.

Empirical analysis of the proposed model confirms the hypothesis of the paper: including in the model variables that represent idiosyncratic risk of a firm outperforms basic pairs trading strategy (distance model). In fact, adding ES, BVPS and TP variables leads to better returns in the analyzed portfolios of IBEX 35 index, Euro Stoxx 50 index and Stoxx Europe 50 Index."

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