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Decomposing Short-Term Return Reversal

Last Updated on 10 February, 2024 by Rejaul Karim

In the realm of short-term return reversal, Zhi Da, Qianqiu Liu, and Ernst Schaumburg present a groundbreaking study, “Decomposing Short-Term Return Reversal.” Offering a meticulous analytical decomposition, the research dissects the profit from a conventional strategy into four components.

Remarkably, only the residual component, capturing reactions to recent “non-fundamental” price changes, emerges as both significant and positive in empirical data. Introducing a straightforward yet potent short-term reversal trading strategy, designed to encapsulate this residual component, the authors unveil a risk-adjusted return three times the magnitude of standard approaches.

This innovative decomposition asserts the pervasive nature of short-term return reversal, surpassing previous assessments, attributing its dynamics to investor sentiment on the short side and liquidity shocks on the long side.

Abstract Of Paper

The profit to a standard short-term return reversal strategy can be decomposed analytically into four components related to (1) across-industry return momentum; (2) within-industry variation in expected returns; (3) underreaction to within-industry cash flow news; (4) and a residual. Only the residual component, which isolates reaction to recent “non-fundamental” price changes, is significant and positive in the data. A simple short-term return reversal trading strategy designed to capture the residual component generates a highly significant risk-adjusted return three times the size of the standard reversal strategy during our 1982-2009 sampling period. Our decomposition suggests that short-term return reversal is pervasive, much greater than previously documented, and driven by investor sentiment on the short-side and liquidity shocks on the long-side.

Original paper – Download PDF

Here you can download the PDF and original paper of Decomposing Short-Term Return Reversal.

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Author

Zhi Da
University of Notre Dame – Mendoza College of Business

Qianqiu Liu
University of Hawaii at Manoa – Shidler College of Business

Ernst Schaumburg
Federal Reserve Banks – Federal Reserve Bank of New York

Conclusion

In conclusion, our decomposition of the profit derived from a standard short-term return reversal strategy reveals crucial insights. Among the four components analyzed, only the residual component, isolating reactions to recent “non-fundamental” price changes, emerges as significantly positive in the data.

This finding underscores the pervasive nature of short-term return reversal, surpassing previous documentation. A strategically designed short-term return reversal approach focusing on the residual component yields a highly significant risk-adjusted return, three times the magnitude of the standard reversal strategy.

Our results point to the influential role of investor sentiment on the short side and liquidity shocks on the long side, shedding light on the nuanced dynamics that drive short-term return reversal.

Related Reading:

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Calendar Anomalies in Stock Index Futures

FAQ

Q1: What is the key innovation in the study “Decomposing Short-Term Return Reversal,” and how does the analytical decomposition contribute to our understanding of short-term reversal strategies?
A1: The key innovation lies in the meticulous analytical decomposition of the profit from a standard short-term return reversal strategy into four components. Among these components, only the residual component, capturing reactions to recent “non-fundamental” price changes, is found to be significantly positive. This decomposition enhances our understanding by isolating and emphasizing the importance of the residual component in short-term reversal dynamics.

Q2: How does the short-term reversal trading strategy designed around the residual component differ from standard approaches, and what are the implications for risk-adjusted returns?
A2: The short-term reversal trading strategy designed to capture the residual component is straightforward yet potent. Remarkably, it generates a highly significant risk-adjusted return three times the size of standard reversal strategies. This highlights the effectiveness of focusing on the residual component and suggests a potential avenue for investors to enhance risk-adjusted returns in short-term reversal strategies.

Q3: What does the decomposition of short-term return reversal profits suggest about the underlying dynamics, and how does it challenge previous assessments of short-term reversal?
A3: The decomposition suggests that short-term return reversal is pervasive, exceeding previous assessments. The dynamics are attributed to investor sentiment on the short side and liquidity shocks on the long side. This challenges previous notions and provides a more nuanced understanding of the factors driving short-term return reversal, emphasizing the role of sentiment and liquidity shocks in shaping its dynamics.

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