Reversal effect in asset prices is a phenomenon of prices overshooting their true values and then subsequently returning to the equilibrium. A typical reversal effect investment strategy sets up a portfolio of different stocks with long positions in past losers and short position in past winners. An excess return is generated by the price reversion to the mean over the trading period which can be a day, week, or a month after which the portfolio is rebalanced. The most cited reason for this behaviour is an overreaction of the markets to new information. General mean reversion is also driven by economic factors such as foreign exchange and interest rates, however the low speed of the mean reversion here makes it difficult to profitably exploit this fact.
The theory of asset pricing postulates a world in which assets are perfectly divisible and markets are frictionless. Market participants are rational and equally observe new information entering the market at the same time. As this hypothetical investor community is representative of the market as a whole, supply and demand must by definition result in market equilibrium. As a result, prices should follow a random walk without any stable patterns of higher prices leading to lower prices and vice versa. Under the perfect markets assumption, reversal strategies should not yield persistent excess returns. Most of the academic research has therefore focused on investigating the impact of market imperfections such as trading costs, liquidity, information asymmetry, capacity constraints or behavioural factors in explaining excess return generated by reversal strategy.
One of the earlier studies reporting a negative serial correlation in prices is of Fama and French (1988). They test a long sample of 1926-1985 data and are able to predict 40 % of the variation in 3-5 year returns. Jagadeesh (1990) finds that return reversal strategy for the US stock market earns a profit of 2.49% per month. This strategy buys loser and sells winner decile portfolios, based on the previous month returns. In addition, Lehman (1990) finds a short term contrarian strategy based on weekly stock returns generating a profit of 1.79 % per week. Similarly, De Bondt and Thaler (1985) show that stock prices overreact to information, suggesting that contrarian strategies (buying past losers and selling past winners) achieve abnormal returns. They show that over 3- to 5-year holding periods; stocks that performed poorly over the previous 3 to 5 years achieve higher returns than stocks that performed well over the same period.
Reversal effect is not isolated to stocks. There are short term reversal strategies in futures, or reversal in international etfs.
Later studies however claim that most of the positive evidence for asset price reversal can be attributed to frictions in the securities markets rather than market inefficiency. This means that investor attempting to arbitrage away reversal opportunities would in reality not earn any excess returns due to presence of cost of trading, cost of capital, liquidity costs, taxes and various trade impediments. Kaul and Nimalendran (1990) show that bid-ask errors in transaction prices are the predominant source of apparent price reversals in the short run for NASDAQ firms. Aramov, Chordia and Goyal (2006) find a strong relationship between short‐run reversals and stock illiquidity contributing to contrarian trading strategy profits being smaller than the likely transactions costs.
De Groot et al. (2012) show that lowering the trading frequency and optimising the choice of short and long portfolios for the trading costs leads to 30-50 basis points per week returns net of trading costs. Frazzini, Israel and Moskowitz (2012) further corroborate the evidence in favour of reversal strategy implementation by finding actual trading costs to be much lower than presumed by most of the previous academic research. Furthermore, Nagel (2012) finds that short-term reversal strategy returns are highly correlated to VIX and can be attributed to large extend to a liquidity provision. Very high returns appear during periods of market turmoil where financial intermediaries and liquidity providers are constrained in their risk bearing ability.
In conclusion, some of the reversal strategies’ attractiveness can be explained by the market imperfections such as trading costs resulting in investor being unable to realistically profit from the apparent mispricing. Despite, a good selection of cheap to trade securities can make the reversal strategy profitable. In addition, there is strong evidence pointing to stable sources of excess returns attributable to abnormal liquidity provision rewards due to diminished liquidity during high volatility periods.