The short-term contrarian strategy of buying stocks, which are past losers and selling stocks, which are past winners, is well documented in the academic literature. But does this affect work within different markets and with different instruments?
Recent research shows that short term reversal works not only in the equity market, but it is also applicable to futures. Research also suggests that trading volume contains information about future market movements. This “forecastability” can be enhanced with open interest as it provides an additional measure of trading activity. Therefore this contrarian strategy is most profitable if it is implemented on high-volume low-open interest contracts.
Evidence of short-horizon return predictability is consistent with the overreaction hypothesis; namely, traders over-adjust their posterior beliefs to news more than it is warranted by fundamentals. Overconfidence and overreaction themselves imply a large volume of trading, and they are thus positively related to the magnitude of price reversals. Therefore an irrationality-induced market inefficiency gives rise to a negative relation between volume and expected returns. Open interest represents uninformed trading by hedgers or hedging activity and thus is also an important determinant of the market state.
per annum, calculated as annualized (arithmetically) weekly returns (0.57%) for long short portfolio from table 5, weekly return to the contrarian portfolio is obtained by dividing the total profits by total long or short investment
estimated from t-statistic
number of opened futures contracts with different backing
not stated
The investment universe consists of 24 types of US futures contracts (4 currencies, five financials, eight agricultural, seven commodities). A weekly time frame is used – a Wednesday- Wednesday interval. The contract closest to expiration is used, except within the delivery month, in which the second-nearest contract is used. Rolling into the second nearest contract is done at the beginning of the delivery month.
The contract is defined as the high- (low-) volume contract if the contract’s volume changes between period from t-1 to t and period from t-2 to t-1 is above (below) the median volume change of all contracts (weekly trading volume is detrended by dividing the trading volume by its sample mean to make the volume measure comparable across markets).
All contracts are also assigned to either high-open interest (top 50% of changes in open interest) or low-open interest groups (bottom 50% of changes in open interest) based on lagged changes in open interest between the period from t-1 to t and period from t-2 to t-1. The investor goes long (short) on futures from the high-volume, low-open interest group with the lowest (greatest) returns in the previous week. The weight of each contract is proportional to the difference between the return of the contract over the past one week and the equal-weighted average of returns on the N (number of contracts in a group) contracts during that period.
Partially - The source research paper doesn’t offer insight into the correlation structure of the proposed trading strategy to equity market risk; therefore, we do not know if this strategy can be used as a hedge/diversification during the time of market crisis. Short term reversal strategy is usually a type of “liquidity providing” strategy, and as such, it usually performs well during market crises. However, reversal strategy is also naturally a “short volatility” strategy; its return increases mainly in the weeks following large stock market declines. Traders must be cautious during crisis during days with high volatility as a reversal strategy usually force traders to buy assets which performed especially bad (and to sell short assets with an extremely positive short term performance).
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