Finance Modelling - Profitable Momentum Trading Strategies - Research Paper Example

Abstract The paper examines the existence of exercises stock returns by employing the trading strategies that exploit the certinaity of short run stock price changes. On the basis of historic returns of the largest data set for 30 different stock of the Dow Jones industrial average. The paper recognizes profitable momentum trading strategies as venture tools for the data set provided in the xls. The outcome depict that the returns on trading strategies can’t be accounted for by just an adjustment on trading securities even though we realized that some proof of a size effect in the Dow Jones stocks market and thus the phenomena cant explain the momentum profits. We found that the profitable venture strategies are in the sub-sample 2014-2015 Introduction We will appraise the profitability of a stock using the momentum strategies using the provided data set for the historic data set. This is significance due to the fact any denunciation of the efficient market hypothesis might an outcome of short period of data as well as raises the doubt of whether the recorded denunciation of the EMH is a property of sample or authentic experiential promptness. We realized that extending the data on stock return back, the momentum effect from the 2015 beyond doesn’t exist in the previous period. Methodology and Data We will examine the null hypothesis of weak form of stock market efficiency by checking whether the stock returns are autonomous over a short period of time. Portfolios are created based on the historic return, with the top batch of the categorized stocks tagged as loser portfolio as well s the bottom level as winner portfolio as well as disposing loser portfolio. The EMH acetates that the winner-loser portfolio will capitulate nil profits. Nevertheless, where the prices of the asset displays mean-reversion in the same period. The examination for the profitability of stock returns using the momentum strategies is on the basis of approach employed DeBondt and Thaler (1985, 1987) as well as Jegadeesh and Titman (1993). The paper will examine the stock profitability where the stocks are allotted to portfolio as per the ranking in the period t on the basis of past J month’s returns. In month t, we structure a winner-loser portfolio, in which a shareholder goes short on the loser portfolio as well as assumes on a long position on the winner portfolio for the following K- month possibility. As results, on the basis of J months of past data, portfolios are held for a possibility of K months subsequent to being effected in month t. The trading strategies entail 3 main procedures. First, is stocks are categorized as per the cumulative continues returns (CCR) for every stock I on historic J months of incessantly compounded monthly returns in the first portfolio creation period. 2nd in every month t, the whole sequence of stock sat that date is separated into 10 Same deciles in rising array on the basis of CCRIs. Stocks are allotted similar numbers to every 10 portfolios. The top deciles are assigned the loser portfolio as well as the bottom line as winner portfolio. In month t, we form a winner-loser portfolio in which an investor goes short on the loser portfolio and assumes on a long position on the winner portfolio. The 3rd procedure of trading rule is to establish the profits of a winner less those of loser portfolio (Winner loser) in which the mean monthly returns from precedent loser portfolios (Rloser ) are less from mean monthly returns of precedent winner portfolios ( Rwinner ): Rwinner loser = Rwinner - Rloser The trading strategies are duplicated for every procedure. Under the null hypothesis of the every possibility, the average returns on the winner-loser portfolio are nil. Under the null hypothesis of the EMH, the average returns on the winner-loser portfolio will be nil. Where the return on the Arbitrage portfolio (Rwinner loser) are considerably dissimilar from nil, we can reject the weak form of the EMH; presumptuous of the transaction costs doesn’t pressure Rwinner loser. Where there is proof of momentum in the security market, the winner-loser portfolio will create considerably abnormal profits. There is evidence of momentum in the stock market, the winner-loser portfolios will generate Potential Problems and Safeguards The venture possibilities deemed span between 3 to 24 months. As such, just dissimilar of winner-loser portfolio returns will be realized rather than abnormal profits for every portfolio, this sis due to the fact that the sensitivity of abnormal returns to the performance benchmark employed over the long possibilities as pointed out by Dimson and Marsh Method Because we employs the LSPD returns for this study, the monthly returns are worked out from the past traded price in whichever month as well as we appreciates that the employment of transaction prices significantly persuaded by bid-ask bounce impact in the data as well as the intricate of non-trading. Serial correlation might be induced by the bid-ask spread impact where the last price of the categorized period is as well the initial price of the post ranking period. The tests are executed on portfolio returns worked out over non-overlapping period. The disadvantage of performing the non-overlapping examination for long possibilities is that there is unavoidable loss of information as well as there is possibility that the economic trend might be a main constituent in establishing the result of momentum strategies because of scarce data range. For descriptive variables with serial correlation, General Method of Moments (GMM) estimators present worse than non-overlapping regressions in creating low standard errors. Momentum on the stock A Nil Momentum strategy entails the purchase of the historic top performing stocks as well as short disposal of the historic stock that is worst performing. For these venture strategies to capitulate positive returns, the historic top performing stocks must continue to better the worst performing stock which implies that the P10 portfolio must provide larger returns than p1-portfolio. The dissimilarities in returns between these portfolios (p10-p1) are nil-cost portfolio return. The returns are depicted in the graph below in which it can be depicted that the most of the strategies depict positive returns within 3-12 months of the venture possibilities. (K3-k12). Within these venture possibilities the momentum strategies depict monthly return ranging from 0.139%-1.6%. The strategies with just a month venture possibilities depict dissimilar outcome. The JK and The J3K1 strategies depict large negative returns while the J12K and the J24K strategy depict large positive returns. Where a momentum strategy capitulate negative returns then it is very appropriate to employ the contrarian strategy which is completely the conflicting. From the above graph, it can be observed that the Momentum Strategies depict a trend of being high for the many of the strategies with 3month to 12 months venture possibilities but then declines as well as vanish with longer periods. With a holding period of 2 years, entire of the strategies depicts nil or somewhat negative returns. Entire of the strategies were statically tested to corroborate the findings of momentum in the stocks. We found that 8 are presented in the table below with buy representing the P10-portoflio as well as the sell repenting the P-1-portofli.in the table below with buy representing the P10-portoflio as well as the sell repenting the P-1-portofolio. The buy sell is the nil-cost portfolio with the t-values depicted below.         MSCI Nordic Mean 1.37% T - statistics       St dev 6,70% 6.70% J K1 K3 K6 K9 K12 K24 1 Buy -0,92% 0,43% 1,12% 1,11% 1,18% 1,18% -1,37 0,68 1,58 1,57 1,70 1,64   1 Sell 1,82% 0,65% 0,98% 0,90% 0,80% 1,17% 3,33 1,11 1,44 1,27 1,16 1,72   1 Buy - Sell -2,74% -0,22% 0,14% 0,21% 0,38% 0,01% -4,72 -0,50 0,33 0,52 1,02 0,02   3 Buy -0,16% 1,13% 1,07% 1,39% 1,44% 1,27% -0,25 1,75 1,74 2,03 2,05 1,71   3 Sell 1,00% 0,77% 0,47% 0,85% 0,87% 1,24% 1,68 1,14 0,73 1,17 1,16 1,72   3 Buy - sell -1,16% 0,36% 0,60% 0,55% 0,57% 0,03% -1,85 0,65 1,33 1,10 1,18 0,05   6 Buy 0,51% 1,50% 1,84% 1,63% 1,55% 1,31% 0,84 2,45 2,66 2,40 2,25 1,71   6 Sell 0,59% 0,30% 1,06% 0,72% 0,82% 1,28% 0,97 0,48 1,36 0,99 1,12 1,68   6 Buy - Sell -0,08% 1,20% 0,79% 0,91% 0,72% 0,04% -0,13 2,39 1,43 1,93 1,49 0,06   9 Buy 1,02% 1,39% 1,88% 1,66% 1,63% 1,28% 1,65 2,34 2,69 2,38 2,32 1,63   9 Sell 0,76% 0,51% 0,83% 0,92% 1,10% 1,28% 1,19 0,76 1,10 1,16 1,39 1,69   9 Buy - Sell 0,26% 0,87% 1,05% 0,75% 0,53% 0,00% 0,42 1,65 1,96 1,29 0,92 0,00   12 Buy 1,73% 1,90% 2,17% 1,93% 1,70% 1,27% 3,45 3,20 3,05 2,59 2,24 1,53   12 Sell 0,12% 0,34% 1,23% 1,34% 1,38% 1,39% 0,20 0,49 1,47 1,53 1,61 1,77   12 Buy - Sell 1,61% 1,56% 0,94% 0,59% 0,32% -0,12% 3,26 2,98 1,55 0,90 0,49 -0,16   24 Buy 1,33% 1,27% 1,17% 1,15% 1,07% 0,83% 3,57 3,40 3,05 2,59 2,24 1,53   24 Sell -0,04% 0,25% 0,51% 0,62% 0,76% 0,95% 0,20 0,51 1,47 1,53 1,61 1,77   24 Buy - Sell 1,37% 1,02% 0,66% 0,54% 0,31% -0,12% 3,43 3,26 1,55 0,90 0,49 -0,16   The table depicts the stock J6K1-24 strategies from the above table. The buy portfolio appear to better the sell portfolios in entire class apart from the J6K1 strategy. As results, the by-sell portfolio depicts positive returns in the 3months to 24 months holing period. Nevertheless, for the J6K24 strategy, the positive returns are small which 0.039% as well as far from the relevant. We may summarize that the momentum strategies works well at the time K3-K12 (0, 73% to 1, and 19%) as well as are important for the J6K3 as well as the J6K9 Strategy. K1 K3 K6 K9 K12 K24   6 Buy 0,5% 1,51% 1,84% 1,63% 1,55% 1,33% 0,84 2,45 2,66 2,40 2,25 1,71   6 Sell 0,59% 0,31% 1,06% 0,72% 0,83% 1,28% 0,97 0,48 1,36 0,99 1,12 1,68   6 Buy - Sell -0,08% 1,20% 0,78% 0,92% 0,72% 0,04% -0,13 2,39 1,43 1,93 1,49 0,06                               A substitute venture is just to invest in the P10-portfolio as well as not short sell the P1-portfolio. The strategy might then be evaluated to a passive strategy which is the buy and hold strategy. In the market index. From the above table, it is obvious that the P10-portolfiio is better than the market index within the time range of 3-12 months venture possibilities. The outcome depict that 14 out of 16 strategies depict worse performance than the market index. There are momentum profits to be made employing the P10-portoflio in the medium term possibilities but not in the short or long term possibilities. Establishing the robustness of the results and conclusions To scrutinize the manner to which the strategies work at the time of dissimilar periods, we carry out a robustness test, in this test; we will divide the time frame into 3 sub-periods which are 2005-2009, 2009-2014 and 2014-2015. Entire of the sub-periods starts in November. The returns for stock J6K1-24 (with t- statistics) are presented in table below. We as well present the MSCI index evaluation. Subsamples Dow Jones 1,84%         2006-2009 St dev 4,63%         J K1 K3 K6 K9 K12 K24 6 Buy -0,13% 1,40% 2,08% 2,17% 2,33% 1,91% -0,11 1,66 2,44 2,55 2,87 2,33   6 Sell 1,30% 1,08% 1,93% 1,52% 1,72% 2,01% 2,2 1,6 1,6 1,96 2,11 2,22   6 Buy - Sell -1,42% 0,32% 0,15% 0,65% 0,61% -0,09%               MSCI Nordic 1,29%           2009-2014 St dev 8,56%         J K1 K3 K6 K9 K12 K24 6 Buy -0,56% 0,25% 0,36% 0,06% 0,04% 1,02% -0,4 0,19 0,26 0,04 0,03 0,77   6 Sell -1,91% -1,91% -0,99% -0,99% -0,59% 0,50% -1,3 -1,37 -0,7 -0,84 -0,6 0,86   6 Buy - Sell 1,35% 2,16% 1,34% 1,05% 0,64% 0,52%               MSCI Nordic 0,86%           2014-2015 St dev 6,77%         J K1 K3 K6 K9 K12 K24 6 Buy 1,76% 2,17% 2,56% 2,25% 1,93% 0,91% 1,87 1,95 1,91 1,8 1,63 0,55   6 Sell 1,34% 0,73% 1,25% 0,89% 0,68% 0,84% 1,14 0,61 0,98 0,64 0,47 0,52   6 Buy - Sell 0,42% 1,44% 1,32% 1,36% 1,25% 0,08% 0,44 1,92 1,74 1,85 1,68 0,07   In the 2005-2009 sub-periods, the J6K6-K24 winner strategies have better the market. The Nil-cost portfolio depicts positive returns in the 3months to 12 months period with the highest returns for the J6K9 strategy. The nil-cost portfolios returns are somewhat low as well as not statistically. The 2009-2014 sub period is somehow dissimilar from the other sub-periods, at the this time, which entails the IT effervesce , it can be realized that the P10 portfolio didn’t perform to the expectation unlike the MSCI index, the cash of the IT stock has likely depicted the large effect in the P10 stocks. The P1-portoflio depicted even much poor performance unlike the p10-stock which is an implication that the Nil-cost portfolio have been gainful with utmost returns fro the J6K3 strategy. 2.15%. This is an important dissimilar from the nil-cost. The 2014-2015 sub-periods is distinguished by bull market. The P10-portoflio strongly better the MSCI index for the entire the venture possibilities. It can as well be depicted that the nil-cost portfolio creates between 1.3% and 1, 5% in the K3-K12 possibilities. These returns are as well all important diverse from Nil. We can therefore conclude this part by determining that the 2006-2009 is in line with the finding for the entire period. The 2009-2014 periods depict low outcome for the P120-portoflios. This is because of numerous IT as well as other glamour stocks that were in the portfolio which succeeding worst performing. Potential clarification of Momentum We have scrutinize the 4 factors that may impact the outcome of the momentum returns in the stock market which are the CAPM-beta, size, Volume as well as Seasonality. Even though, these factors have been examined on strategies from each stock, we consider the presentation of the J6K6 strategy to be enough for exhibiting dissimilarities between the P1-P10 portfolios within dissimilar strategies. The factors are officially statistically examined to test whether there are any substantial dissimilarity between the portfolios, the seasonality effect aren’t examined between the portfolios, as an alternative it provides an overview of the manner to which momentum strategies have perform in diverse months. The CAPM Beta The graph below depicts the CAPM-beta for the diverse portfolio employing the J6K6 strategy. The beta is worked out employing the 24 months past returns as well as the index appraised against the MSCI index. We decided to work pout the beta with 24 months past returns as well long to get rid of losing numerous observations. The CAPM-betas depict dissimilarities between portfolios which are an intricate exercise in pointing out specific portfolio that is significantly diverse from other portfolios. Nevertheless, the P10 and P9 portfolios depict high values of 0.73 and 0.63 but the highest difference as well, the statistical test corporate that there are significant variations among the portfolios (p=0) is merely 0.13. The strategy has capitulated an average yearly return of almost 11% over the sample period. The risk adjusted returns is therefore high which implies that it is improbable that the market risk might explain the momentum. Correlations of momentum profits In the case of investing in stock prices, it is significant to take into consideration the patterns in correlation. Low correlating would mean less risk likeliness because of diversification. High correlation will minimize the advantage of venturing in numerous stocks. Table P10-portflio, the Stock indices as well as the correlations for the market nil-cost portfolio against the local stock index the outcome are from the J6K6 strategies. Panel A       Part A   Correlation matrix P10-P1   1.0   0,6 1.0 0,22 -0,02 0,15 0,47     PART B   correlation matrix P10   1   0,89 1 0,43 0,31 0,51 0,71     PART C   Correlation matrix MSCI indices   0,69 1 0,87 0,68 0,92 0,57 Optimal portfolio strategies In our assessment, we have centered on J6K6 strategy to be in a position to comparison with our outcome with the previous research. We will detail on the most advantageous strategies in the stock prices as well as diverse stock market. It can be observed that there are some strategies that seem to be more gainful among the entire stocks as well as sub-periods. The J12K1 as well as the j12k3 strategies creates relevant positive returns for many stock time periods. The t-statistics doesn’t point out importance as much as the monthly return depicts a return above 0.01 a month. The higher the volatility is the likely due to the fact that the stock prices are large components in the stock Dow Jones stock market. A lot of movement in the stock prices is created by a single firm implying that the firm specific risk is high. The J12K1 is a whole slightly more gainful t=unlike the J12K3 strategy. The J12K1 strategy depicts a great weakness. Because the holding period is merely a month, the portfolio should be rebalanced frequently which would lead very high cost. Consequently, we have selected the current J12K3 strategy in the graph below. The strategy has a venture possibility of three months with an implication that the portfolio needs to be rebalanced four times per annum. The graph depicts the P10 portfolio, the nil-cost portfolio as well as the stock index for assessment. The graph above depicts the development of a venture of $100 in the J12K3 stock strategy. The nil-cost portfolio has is the least volatile as well as performing in line with their market index. The portfolio didn’t portray the large volatility since the market is under the system intricacies. To venture in the winners P10, has been a gainful as well as $100 venture might be valuable almost $2000. The viability of the momentum strategies is as well assumed to be autonomous on the number of stakeholders who employs them. Where numerous investors start to use the strategies, the momentum impact will vanish. The momentum effect will afterwards be taken into consideration in valuation as well as stock will be prized consequently. Considering the realistic effect of employing the nil-cost momentum strategy, it is difficult to from a solid judgment of whether the strategy is advantageous in comparison with the buy and hold strategy. We cannot appraise the effect of transaction cost for the specific investor employing diverse venture strategies, other research on momentum what centers on trading cost issues have reached conclusion of the impact on the viability. On the other hand, we strongly believe that the P10 momentum strategy is ideal strategy to employ when making an investment in the stock. The outcome as well as other studies have depicted that the strategies tend to perform well unlike the market index eventually. Elucidating Momentum with behavioral finance The notion of Homo Economicus, a fictive person which continuously makes normal verdicts, is far better explanation of stock market investor. The investor need to employ the rules of thumps in generating huge amount of information. This will lead to errors of judgment in some situations. These sorts of attitude among investors might develop into patterns in the stock prices. It is complex to find cogent clarification for momentum. Nevertheless, employing behavioral models as well as additional experiential testing, the momentum effect may be explained. An ideal behavioral explanation might be that the investor under react to latest information. The under reaction attitude might be caused by a scarce capability among most of the investor to access as well as generate information. Investors might be over confident leading to investors, maintaining their original perception when encountering latest information. Where the investor at first under react to the latest information then the price may be gradually be regulated so as current. If a comparison is made between P10 strategy and the passive index venturing strategy, we realize that the P10 strategy has better the market. The P10 strategy has better the market significantly at the time of latest four years bull market. For a long time just investors, it seems that momentum strategy such as this will be very gainful unlike the passive index venture strategy. Extra explanation on the observed outcome The findings of the substantial positive returns from the momentum strategies mean that the stock is inefficient. As per the efficient market hypothesis, it must unfeasible to get relevant abnormal return over time employing the momentum strategies on the basis of past information. Even the weak from of market efficiency are not supported with the result of the momentum strategies. Issues when putting Momentum Strategies into practice Employing the momentum strategy is risk free. An investor will experience lost of uncertainty in the stock market, even with nil-cost portfolio strategy. Moreover, historic price trend is never an assurance for the similar behavior in the prospect. Large positive return for the momentum strategy might be clarified by the capital asset pricing model betas (CAPM-betas) or the size of the business. The outcome of our research point out that the momentum strategy is superior to passive buy as well as hold strategy. Taking into consideration the return as well as risk of a venture, the explanation goes both for the nil-cost portfolio as well as venture in P10 portfolio. Nevertheless, there are some realistic insinuations in employing the nil-cost portfolio in the momentum strategy which impact the viability. The strategy entails short disposal of stocks. In parties, short disposal if socks might but be likely. Normally, this is scarce merely to the largest as well as the most added stocks. Short disposals of stocks are expensive unlike taking long condition. The holder of the short position should pay a portion fee to the lender of the stock. The nil-cost momentum strategy as well twice the number of transaction for the investor. As results, the transaction cost will be larger for the momentum strategies in comparison with the buy and hold strategy. Conclusion The result of the study depicts momentum profits to be made in entire of the provided stock prices with three to twelve months venture possibilities. The nil-cost portfolio creates almost 0.01 returns every month well as the p10 portfolio inclusive of the top performing stocks steadily beat the market index on average. Nevertheless, strategies with short venture possibilities of a month create substantial negative momentum profits. A more significant strategy will be the contrarian strategy, diametrically diverse from the momentum strategy. Other strategies with two years venture possibilities depict no momentum profits due same returns for the P10 and 02 portfolios. The nil-cost portfolio for the J24k strategy depicts each month returns of 1.4%. We scrutinized 4 factors as well as their impact on the momentum profits for the J6K6 strategy on the stock prices. The CAPM-betas depicted to be slightly higher for P01 as P1 portfolio. These portfolios are as a result a bit more risky in comparison with other portfolios. Nevertheless, the nil-cost portfolio betas were merely slightly positive, however they created significant returns. We don’t consider that higher risk might entirely explain the momentum return. The CAPM-betas depicted to be questionable in illumination the momentum effect. The size of the company of the diverse portfolios for the J6K6 strategy depicted to be f=just same among the portfolio apart from the P1 portfolio which seems to be inclusive of numerous smaller stocks. This might have been a concern evacuee smaller firms have created larger returns at a high risk. If the P10 portfolio entailed smaller stocks, this might have been a sign that the momentum return merely was recompense for risk. Nevertheless, it was realized that the opposite were correct. This implies that the risk appraised as size of the company might not explicate the momentum effect. Reference list Assoé & Sy (2003), Profitability of the Short -Run Contrarian Strategy in Canadian Stock Markets, Canadian Journal of Administrative Sciences, Dec 2003 Banz, R.W. 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