New strategies:
#237 – Dispersion Trading
Period of rebalancing: Monthly
Markets traded: equities
Instruments used for trading: options
Complexity: Very complex strategy
Bactest period: 1996 – 2007
Indicative performance: 15.39%
Estimated volatility: 13.86%
Source paper:
Buraschi, Trojani, Vedolin: EQUILIBRIUM INDEX AND SINGLE-STOCK VOLATILITY RISK PREMIA
https://workspace.imperial.ac.uk/riskmanagementlab/public/wp05.pdf
Abstract:
Writers of index options earn high returns due to a significant and high volatility risk premium, but writers of options in single-stock markets earn lower returns. Using an incomplete information economy, we develop a structural model with multiple assets where agents have heterogeneous beliefs about the growth of firms’ fundamentals and a business-cycle indicator and explain the different volatility risk premia of index and single-stock options. The wedge between the index and individual volatility risk premium is mainly driven by a correlation risk premium which emerges endogenously due to the following model features: In a full information economy with independent fundamentals, returns correlate solely due to the correlation of the individual stock with the aggregate endowment (“diversification effect”). In our economy, stock return correlation is endogenously driven by idiosyncratic and systemic (business-cycle) disagreement (“risk-sharing effect”). We show that this effect dominates the diversification effect, moreover it is independent of the number of firms and a firm’s share in the aggregate market. In equilibrium, the skewness of the individual stocks and the index differ due to a correlation risk premium. Depending on the share of the firm in the aggregate market, and the size of the disagreement about the business cycle, the skewness of the index can be larger (in absolute values) or smaller than the one of individual stocks. As a consequence, the volatility risk premium of the index is larger or smaller than the individual. In equilibrium, this different exposure to disagreement risk is compensated in the cross-section of options and model-implied trading strategies exploiting differences in disagreement earn substantial excess returns. We test the model predictions in a set of panel regressions, by merging three datasets of firm-specific information on analysts’ earning forecasts, options data on S&P 100 index options, options on all constituents, and stock returns. Sorting stocks based on differences in beliefs, we find that volatility trading strategies exploiting different exposures to disagreement risk in the cross-section of options earn high Sharpe ratios. The results are robust to different standard control variables and transaction costs and are not subsumed by other theories explaining the volatility risk premia.
#238 – Reversal in Post-Earnings Announcement Drift
Period of rebalancing: Daily
Markets traded: equities
Instruments used for trading: stocks
Complexity: Complex strategy
Bactest period: 1996 – 2010
Indicative performance: 40.32%
Estimated volatility: not stated
Source paper:
Miliian: Overreacting to a History of Underreaction?
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2229479
Abstract:
Prior research has documented a long history of positive autocorrelation in firms’ earnings announcement news. This is one of the main features of the post-earnings announcement drift phenomenon and is typically attributed to investors’ underreaction to earnings news. I document that this autocorrelation has become significantly negative for firms with active exchange-traded options. For these easy-to-arbitrage firms, the firms in the highest decile of prior earnings announcement abnormal return (prior earnings surprise), on average, underperform the firms in the lowest decile by 1.29% (0.73%) at their next earnings announcement. Additional analyses are consistent with investors learning about post-earnings announcement drift and overcompensating. It seems that due to their well-documented history of apparently underreacting to earnings news, investors are now overreacting to earnings announcement news. This paper shows that attempts to exploit a popular trading strategy based on relative valuation can significantly reverse the previously documented pattern.
New research papers related to existing strategies:
#234 – Carry Factor within Asset Classes
Ahmerkamp, Grant: The Returns to Carry and Momentum Strategies: Business Cycles, Hedge Fund Capital and Limits to Arbitrage
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2227387
Abstract:
We find that global time series carry strategies (across bonds, commodities, currencies, equities and metals) can be explained by a set of lagged macroeconomic variables. The payoffs to carry strategies disappear once futures returns are adjusted for their predictability based on these macroeconomic variables. On the other hand, momentum strategies are only weakly affected by lagged macroeconomic variables but are significantly related to measures of hedge fund capital flow. When studying these two findings together and over time we find that while momentum strategies were highly co-moving with carry strategies and therefore business cycle predictors between 1994 and 2002, when Hedge Fund AUM was low, correlation has since decreased. The decrease in correlation has coincided with significant increases in hedge fund AUM, and limits to arbitrage have become more relevant in explaining momentum returns. We embed these findings within a broad empirical investigation of time series carry and momentum strategies across 55 futures contracts spanning the asset classes bonds, currencies, commodities, equities and metals. Our results provide a possible avenue for identification strategies to disentangle the role of limited arbitrage effects on futures returns and systematic risks that are associated with time-varying expected returns in explaining momentum returns.
