Preventing Crashes: Enhanced Reversal Strategy in Chinese Stock Market

Abstract

In this paper, we find the stock returns of Chinese market exhibit reversal instead of momentum behavior from short to long horizons. While the traditional reversal strategies can generate economically large average returns in the Chinese market, they bear infrequently extreme downside risks. We hence propose enhanced reversal strategies by adding a stop-loss line to limit crash risk and constructing a composite reversal strategy to better select stocks. Our enhanced reversal strategy consistently provides stronger evidence of return reversal than does the traditional reversal strategy by doubling the Sharpe ratio, generating a vast monthly return of 1.75% and reducing the largest downside loss from -28.82% to -8.34%. The abnormal returns cannot be explained by the standard risk factor and are stronger among stocks with larger limits to arbitrage.