Short Term Reversal Effect in Stocks

The short-term reversal anomaly, the phenomenon that stocks with relatively low returns over the past month or week earn positive abnormal returns in the following month or week, and stocks with high returns earn negative abnormal returns, is well-researched, where a lot of research has been made about this particular anomaly. However, the researchers hypothesize that reversal strategies require frequent trading and rebalancing in disproportionately high-cost securities, and this would lead to a situation where trading costs prevent profitable strategy execution. The results might be interpreted in a way that the abnormal returns of reversal investment strategies, which were documented in studies, create an illusion of profitable investment strategies. Still, due to the transaction costs, the strategies are not applicable, and the profitable strategies do not exist.
However, research has found that the impact of trading costs on reversal profits can largely be attributed to excessively trading in small-cap stocks. Therefore there exists a solution on how to make a reversal strategy profitable, even when the transaction costs are included, but the potential investor must modify the basic strategy. Said, the turnover of standard reversal strategies is excessively high. The solution to this problem is simple; the strategy has to be traded on stocks with a larger market capitalization. The aforementioned lead to a profitable and both economically, and statistically significant strategy, which sells past winners, and buys recent losers, but is slightly modified in terms of the size of the stocks. Moreover, the paper also presented research about European stocks and found that if the investor invests in the stocks with larger market capitalization, the reversal strategy will work. Last but not least, the ability of the reversal anomaly to survive trading costs was also studied in the paper Frazzini, Israel, and Moskowitz: Trading Costs of Asset Pricing Anomalies.

Fundamental reason

Past research speculates that the fundamental reason why does the reversal anomaly work is the investor’s overreaction to the past information and a correction of that reaction after a short time horizon. The work of Stefan Nagel in the paper Evaporating Liquidity claims that returns of short-term reversal strategies in equity markets can be interpreted as a proxy for the returns from liquidity provision and shows that reversal anomaly returns closely track the returns earned by liquidity providers.
Overall, there is a mutual consent that theoretically, reversal strategy does work. However, there is a problem with the transaction costs that make the strategy inapplicable. This paper and also the work of de Groot, Wilma, and Huij, Joop and Zhou, Weili: Another Look at Trading Costs and Short-Term Reversal Profits proved that the strategy works if the investor focuses purely on the larger stocks, what reduces the transaction costs. Moreover, research of this paper has used the Nomura cost estimates instead of the trading cost estimates resulting from the Keim and Madhavan model, because trading costs of the model are substantially lower than the Nomura cost estimates and the trading costs of Keim and Madhavan model can even be negative in many cases. Therefore, the results from the Keim and Madhavan model should be interpreted with caution and probably should not also be used.
Moreover, an additional attractive feature of the trading cost model, which was obtained from the Nomura Securities, is that it has also been calibrated using European trade data, which eases the analysis of the European stocks. Lastly, the study has found that net reversal profits are significant and positive among large-cap stocks over the most recent decade in the sample, which is characterized by the dramatically increased market liquidity. This rules out the explanation that reversals are induced by inventory imbalances by market makers and that the contrarian profits are compensation for bearing inventory risks.

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Markets Traded
equities

Financial instruments
stocks

Confidence in anomaly's validity
Strong

Backtest period from source paper
1990-2009

Notes to Confidence in Anomaly's Validity

Indicative Performance
16.25%

Period of Rebalancing
Weekly

Notes to Indicative Performance

per annum, the net return for the strategy with 100 largest stocks and weekly rebalancing, annualized (geometrically) net weekly return 0,29% from Table 7 Panel C


Notes to Period of Rebalancing

Estimated Volatility
14.94%

Number of Traded Instruments
20

Notes to Estimated Volatility

estimated from t-statistic from Table 7 Panel C


Notes to Number of Traded Instruments

Maximum Drawdown
0%

Complexity Evaluation
Complex strategy

Notes to Maximum drawdown

not stated


Notes to Complexity Evaluation

Sharpe Ratio
1.09

Simple trading strategy

The investment universe consists of the 100 biggest companies by market capitalization. The investor goes long on the ten stocks with the lowest performance in the previous week and goes short on the ten stocks with the greatest performance of the prior month. The portfolio is rebalanced weekly.

Hedge for stocks during bear markets

Yes - Equity reversal strategy is usually a type of “liquidity providing” strategy, and as such, they typically perform well during market crises. However, reversal strategy is also naturally a type of “short volatility” strategy; their returns increase mainly in the weeks following large stock market declines. Traders must be cautious during crises during days with high volatility as reversal strategies usually force traders to buy stocks which performed especially bad (and to sell short stocks with an extremely positive short term performance). This position is emotionally hard to open, and risk management of reversal strategies must also be very strict during these days. We recommend reading a research paper by Nagel: “Evaporating Liquidity” to gain insight into the behavior of reversal strategies during crises.

Source paper
Strategy's implementation in QuantConnect's framework (chart+statistics+code)
Other papers

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