The profitability of equity trading strategies

  • Parichat Sinlapates

Student thesis: Doctoral Thesis

Abstract

Classification based on the attributes of firms’ or stocks’ performance is one of the commonly used methods in stock selection. This is known as style investing. This thesis examines three style investing techniques that classify stocks in different ways: (a) historical return based trading strategies, (b) value versus growth trading strategies, and (c) corporate solvency based trading strategies. In the context of these strategies this thesis aims to address two main research questions (a) can these trading strategies generate superior profits?, and (b) can risk, business cycles, and/or investors’ sentiment explain the profitability of these strategies? The three-factor model by Fama and French (1993) is mainly used to control for risk. The investors’ sentiment introduced by Baker and Wurgler (2006) and CLI index compiled by OECD are employed as the factors to investigate the role of investors’ sentiment and business cycles, respectively. Chapter 2 of the thesis deals with the historical return based trading strategies. Under this criteria portfolios are formed on the basis of trends in historical returns. The two commonly used trading strategies that involve analysis of historical return trends are momentum and contrarian trading. Going long (short) on winnerstocks and short (long) on loser stocks is called momentum (contrarian) trading. Momentum profit is generated if the return from the strategy of going long on winnerstocks and short on loser stocks is positive (i.e. returns from long position minus returns from short position are positive). The findings of this thesis, however, do not provide evidence of momentum profit when conventional methods of momentum trading strategies are applied. On the other hand, if the returns from the strategy of going long on loser stocks and short on winner stocks (i.e. contrarian) are positive, then contrarian profit exists.The finding of this thesis provides evidence of contrarian profit in the short-horizon and long-horizon when conventional contrarian trading strategies are applied. When the three-factor model is applied to control for risk, the intercept is statistically significant. This suggests contrarian profits are not explained by risk. Similar results are found after incorporating the investors’ sentiment factor into the model. This suggests contrarian profit exists even when controlling for both risk and investors’ sentiment – contrarian profit cannot be explained by risk and investors’ sentiment. This thesis also employs the residual trading strategies, which form portfolios on the basis of residual returns. The residual contrarian profit, however, cannot be observed when portfolios are formed on the basis of residual returns. In Chapter 3 this thesis examines whether strategies involving going long on value stocks and short on growth stocks generate superior returns. Value investors believe that value stocks are undervalued while growth stocks are overvalued but they should be correctly priced in the future, leading to excess returns. The value versus growth trading strategies are expected to generate profits, which are called value premiums. The findings of this thesis provide evidence that value premiums are persistently observed for all holding periods. The observed value premium exists even after controlling for risk, suggesting that the value premium is not driven by risk. A positive and significant coefficient of business cycle factor is observed after the business cycle factor is incorporated into the three-factor model (i.e. after controlling for risk).This finding suggests that the value premium is positively driven by stages of the business cycle. The value premium, however, cannot be explained by investors’ sentiment. At the industry level, the value premium of some industries (i.e. Consumer Durables, Manufacturing, Business Equipment, Shops, and Health) can be expl
Date of Award1 Oct 2016
LanguageEnglish
Awarding Institution
  • University Of Strathclyde
SupervisorKrishna Paudyal (Supervisor) & Leilei Tang (Supervisor)

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