Stock price reversals following end-of-the-day price moves█ Stock price reversals following end-of-the-day price moves
In the intriguing world of stock trading, the research paper "Stock price reversals following end-of-the-day price moves" by Andrey Kudryavtsev takes a deep dive into the dynamics of stock price behavior, particularly focusing on interday reversals.
Key to this study is the exploration of potentially profitable contrarian strategies. Preceding research has shown that these strategies, which bet against the current market trends, can yield significant abnormal returns – approximately 1.7% weekly and 2.5% monthly.
The study analyzes thirty stocks from the Dow Jones Industrial Index, focusing on high-to-close and low-to-close price differences. It finds that stocks usually have higher returns following days with significant end-of-day price drops and lower returns after days with end-of-day price rises. These patterns suggest a market correction of overreactions. Based on these findings, the construction of daily-adjusted portfolios shows significantly positive returns, indicating the profitability of trading strategies based on these reversal patterns.
█ Research Background and Hypothesis
In stock trading, the concept of price overreaction is not new. Prior studies have established that stock prices often overreact to news, leading to a subsequent correction or reversal to a more 'fair' reaction level.
This is particularly evident in intraday stock price movements, where overreactions and reversals are commonly observed. To investigate this, the study utilizes high-to-close and low-to-close stock price differences as proxies for end-of-the-day price decreases and increases. These price differences are compared for each stock in the sample and on each trading day.
The hypothesis is that the daily return of a stock will be higher if its previous day's high-to-close difference is greater than the low-to-close difference.
█ Methodology
Let's get into the nuts and bolts. The study focused on thirty stocks that form the Dow Jones Industrial Index. Trading data from January 2, 2002, to September 30, 2011, encompassing 2,456 trading days was analyzed. Kudryavtsev used these stocks' daily high, low, and closing prices, as recorded on finance.yahoo.com. But it wasn't just a straightforward data grab.
The prices were meticulously adjusted for dividend payments and stock splits. This adjustment was done by multiplying each actual price by the ratio of the day's reported adjusted closing price (as per Yahoo Finance) to the actual closing price.
⚪ For each stock and for each trading day (except the first day of the sampling period), two key metrics were calculated:
High-to-Close Price Difference (RHCit): This measures the difference between the stock’s daily high and closing price.
RHCit := math.abs(high - close) / close * 100
Low-to-Close Price Difference (RLCit): The difference between the stock’s daily low and closing price.
RLCit := math.abs(low - close) / close * 100
These differences are expressed as absolute percentage price differences, ensuring they are non-negative values. By focusing on these two metrics, the study aimed to capture the essence of the stock's performance and its potential for a reversal the following day.
█ Findings and Analysis
For most stocks analyzed (28 out of 30), mean daily returns were higher following days with dominant high-to-close price differences, i.e., days closed with price decreases.
This trend was statistically significant for most of these stocks, with 22 showing significant mean return differences at the 5% level, including 15 at the 1% level.
Furthermore, for most stocks (29 out of 30), mean daily returns were positive when the previous day's high-to-close price difference prevailed and negative when the low-to-close difference did.
These results support the study's hypothesis, demonstrating a pattern of reverting behavior in stock prices following end-of-the-day price moves. Such findings contribute to the existing literature on stock price overreactions and market inefficiencies and suggest potentially profitable opportunities for traders who can capitalize on these predictable reversal patterns.
█ Implications for Traders
Andrey Kudryavtsev's study offers valuable insights for traders, especially those focusing on short-term investments. The key findings highlight a consistent pattern where stocks tend to reverse their price movement the following day after significant end-of-day changes.
For traders looking to capitalize on these insights, the study suggests constructing portfolios that adjust daily based on the observed reversal pattern. This involves holding long positions in stocks expected to yield high returns (following large high-to-close price decreases) and short positions in stocks expected to yield low returns (following large low-to-close price increases).
By comparing the high-to-close and low-to-close price differences to the mean and median measures for the total sample, traders can identify stocks likely to follow the reversal pattern. This approach could be particularly effective for day traders or those who make frequent, short-term trades, as it leverages the daily fluctuations in stock prices. However, traders need to consider transaction costs and market volatility, which can impact the profitability of such strategies.
█ Reference
Kudryavtsev, A. (2013). Stock price reversals following end-of-the-day price moves. Economics Letters, 118(3), 203-205
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