Effects of order flow imbalance on short-horizon contrarian strategies in the Australian equity market

Abstract

We use Lo and MacKinlay's [Lo, A.W., MacKinlay, C., 1990. When are contrarian profits due to stock market overreaction? The Review of Financial Studies 3, 175–205.] contrarian portfolio approach to examine the profitability of short-horizon contrarian strategies in the context of the Australian Stock Exchange. The results show that simple contrarian strategies lead to small but still statistically significant profits when applied to daily and intra-day portfolio formation. However, the profits are not sufficient to cover transaction costs for institutional investors. The source of contrarian profits is also analyzed leading to the conclusion that stock market overreaction is found to be the primary source of contrarian profits. We also examine the relation between the degree of return reversal and order flow activity after abnormal price changes. We find that the degree of return reversal is positively related to the level of order flow imbalance. Larger profits are generated from order flow based contrarian strategies when the order flow imbalances are high.