Profitable Trading Strategies Research Articles

Quantitative spread trading on crude oil and refined products markets

Quantitative trading in oil-based markets is investigated over 2003–2010, with a focus on WTI, Brent, heating oil and gas oil. A total of 861 spreads are considered. A novel optimal statistical arbitrage trading model is applied, with generalised stepwise procedures controlling for data snooping bias. Aggregating upward and downward mean-reversion, profitable strategies are identified with Sharpe ratios greater than 2 in many instances. For the top categories, average daily returns range from 0.07 to 0.55%, with trade lengths of 9–55 days. A collapse in the number of profitable trading strategies is seen in 2008. Robustness to varying transactions costs is examined.

Discovering a Profitable Trading Strategy in an Apparently Efficient Market: Exploiting the Actions of Less Informed Traders in Speculative Markets

Abstract: This study explores the extent of mispricing in a market for state contingent claims that is commonly believed to be efficient, the UK horserace betting market. We develop conditional logit models for weekend and weekday markets and show that prices are inefficient at weekends when the presence of a larger proportion of less informed bettors results in mispricing. A Kelly investment strategy focused on high probability outcomes in such markets yields considerable positive returns. We identify the need for research exploring the implications for information suppliers and users, regulators and operators in wider financial markets.

The Application of SAS® Hash Object to Ultra-High Frequency Financial Data: A Case Study in Limit Order Book Reconstruction

Over the last decade, the increased availability of ultra-high frequency (UHF) financial data on trades, quotes and order flows in electronic order-driven markets has led to significant innovations in the fields of the empirical microstructure and quantitative analysis of financial markets. Unfortunately, the enormous size of these UHF datasets, usually several million observations per stock per day, has brought up new data processing and handling, in addition to computational challenges. In today’s trading environment, the key challenge posed by UHF data is how one can efficiently and more importantly, quickly exploit a massive dataset to develop consistent and profitable (alpha generating) algorithmic trading strategies. Central to this exercise is the complete and accurate reconstruction of the electronic limit order book (LOB) of order-driven markets. This paper attempts to address the research challenge presented by UHF data by demonstrating the application of SAS® Hash Object to the reconstruction of SETS (Stock Exchange Electronic Trading Service) electronic LOB of the London Stock Exchange (LSE).

Retornos Anormais no Ibovespa Utilizando Modelos para Dados de Alta Frequência

Este artigo tem como objetivo identificar estratégias de negociação lucrativas com base nos efeitos de liderança e na defasagem entre os mercados acionários à vista e futuro no Brasil, utilizando dados de alta frequência. Para alcançar esse objetivo e com base nos dados históricos do índice Bovespa e do índice Bovespa Futuro construíram-se quatro modelos econométricos de previsão: ARIMA, ARFIMA, VAR e VECM. As estratégias de negociação testadas foram: estratégia de negociação líquida, estratégia de compra e manutenção da posição e estratégia de filtro com a média. O período de análise desse artigo estende-se de 1 de agosto de 2006 a 16 de outubro de 2009. Neste trabalho, foi possível obter retornos anormais com a utilização de estratégias de negociação com o modelo VAR sobre os efeitos de liderança e defasagem entre o índice Bovespa e o índice Bovespa Futuro.

Predictability in implied volatility surfaces: evidence from the Euro OTC FX market

Recent general equilibrium models prescribe predictable dynamics in the volatility surfaces that are implied by observed option prices. In this paper, we investigate the predictability of surfaces, using extensive time series of implied volatilities from over-the-counter options on eight different currencies, quoted against the Euro. We examine implied volatility surfaces in the context of predictability through three different models, two that employ parametric specifications to describe the surface and one that decomposes it into latent statistical factors. All examined models are shown to (a) accurately describe the surfaces in-sample, and (b) produce forecasts that are superior to hard-to-beat benchmarks that ignore information about the shape of the surface, in medium- to long-term horizons. We show that these forecasts can support profitable volatility trading strategies in the absence of transaction costs. Comparing across competing models, our results suggest that parametric models, that allow for a more structured description of the surface, are more successful in terms of forecasts’ accuracy and significance of trading profits.

The efficacy of Regulation SHO in resolving naked shorts

PurposeOn January 3, 2005, Regulation SHO was implemented by the Securities and Exchange Commission, with the express purpose of updating short sale regulation by seeking to limit an abusive short selling practice known as naked short selling. The purpose of this paper is to examine the efficacy and impact of Regulation SHO in achieving this goal of reducing naked shorting.Design/methodology/approachTime series analysis using fixed effects regression, Fama‐French‐Carhart model, various parametric and non‐parametric tests. The paper tests a number of hypotheses regarding the effectiveness of Regulation SHO in controlling naked shorts/fails‐to‐deliver in the American stock markets.FindingsUtilizing several models, the authors find strong evidence in the first 30 to 60 days after being identified by Regulation SHO as having excessive naked short positions, those securities on average experienced further significant negative abnormal returns, indicating the regulation was at best ineffective. This result is robust for a number of parametric and non‐parametric tests. Models also show a security identified by Regulation SHO as having an excessive short position may actually suggest a profitable trading strategy of continuing to short those stocks. The regulation was largely ineffective/insignificant in reducing naked shorting. In addition, results revealed that a profitable investment could be made by shorting stocks as they were identified by Regulation SHO as already having excessive outstanding failure positions.Originality/valueThis is the first paper, to the authors' knowledge, that considers whether SHO was effective and offers intuition as to reasons why it was not.

The Meaning of Market Efficiency

Fama (1970) defined an efficient market as one in which prices always “fully reflect” available information. This paper formalizes this definition and provides various characterizations relating to equilibrium models, profitable trading strategies, and equivalent martingale measures. These various characterizations facilitate new insights and theorems relating to efficient markets. In particular, we overcome a well known limitation in tests for market efficiency, i.e., the need to assume a particular equilibrium asset pricing model, called the joint-hypothesis or bad-model problem. Indeed, we show that an efficient market is completely characterized by the absence of both arbitrage opportunities and dominated securities, an insight that provides tests for efficiency that are devoid of the bad-model problem. Other theorems useful for both the testing of market efficiency and the pricing of derivatives are also provided.

THE MEANING OF MARKET EFFICIENCY

Fama defined an efficient market as one in which prices always “fully reflect” available information. This paper formalizes this definition and provides various characterizations relating to equilibrium models, profitable trading strategies, and equivalent martingale measures. These various characterizations facilitate new insights and theorems relating to efficient markets. In particular, we overcome a well‐known limitation in tests for market efficiency, i.e., the need to assume a particular equilibrium asset pricing model, called the joint‐hypothesis or bad‐model problem. Indeed, we show that an efficient market is completely characterized by the absence of both arbitrage opportunities and dominated securities, an insight that provides tests for efficiency that are devoid of the bad‐model problem. Other theorems useful for both the testing of market efficiency and the pricing of derivatives are also provided.

Ideas in Algorithmic Trading and System Modeling for Pedestrians

This document explains the different processes and steps involved in building robust and stable algorithms to unfold financial time series into profitable trading strategies.

Quantitative Spread Trading on Crude Oil and Refined Products Markets

Quantitative trading in oil based markets are investigated over 2003-2010, with focus on WTI, Brent, heating oil and gas oil. A total of 861 spreads are considered. A novel optimal statistical arbitrage trading model is applied, with generalised stepwise procedures controlling for data snooping bias. Aggregating upward and downward mean-reversion, profitable strategies are identified with Sharpe ratios greater than 2 in many instances. For the top categories, average daily returns range from 0.07%-0.55%, with trade lengths of 9-55 days. A collapse in the number of profitable trading strategies is seen in 2008. Robustness to varying transactions costs is examined.

Does Market Impact Reduce Profitability of Institutional Trading Strategies?

This paper examines the impact on the profitability of trading strategies for institutional investors with market impact. A benchmark for the performance of large trades among institutional investors, volume weighted average price (VWAP) is used as a proxy for the execution price of large trades. A representative set of technical rules, including the moving average and trading range break-out rules, are tested on the NYSE/AMEX securities with the NYSE TAQ data set from 1993 to 2005. Closing price and VWAP are also compared in the usage as execution prices and trading strategy generators. In the evaluation of a set of popular trading rules in technical analysis, the empirical results show that VWAP is less profitable than closing price, while the improvement of returns using VWAP price as trading strategy generator instead of closing price is not significant.

Investor sentiment and calendar anomaly effects: A case study of the impact of Ramadan on Islamic Middle Eastern markets

The holy month of Ramadan is usually a time of celebration and renewal in Muslim countries. This paper examines whether or not this is reflected in positive calendar anomalies effects in Islamic Middle Eastern stock markets during the period 1992–2007. Strong evidence is found of significant and positive calendar effects in respect to the whole period of Ramadan in most countries and it is argued that this can be attributed to the generally positive investor mood, or sentiment. Although Ramadan is a time of celebration for Muslims it also can be a time of uncertainty and this appears to result in the impact of the festival not being uniformly positive throughout Ramadan. It is found that market returns in the first and last days of Ramadan show high levels of statistically significant year-on-year variation. It is argued that this can possibly be attributed to synchronization-related herding effects amplifying the impact of the mood swings associated with this period. The paper also finds that although the overall Ramadan effect is both positive and statistically significant for most countries, the associated gains were only large enough to outweigh transactions costs and provide the basis of a profitable trading strategy in one market.

How important is the term structure in implied volatility surface modeling? Evidence from foreign exchange options

We claim that previously proposed parametric specifications that linearly approximate the term structure of the implied volatility surface (IVS) in option prices fail to capture important information regarding the expectations of market participants. This paper proposes a parametric specification for describing the IVS that allows flexible modeling of the term structure through a Nelson and Siegel (1987) factorization, recently proposed by Diebold and Li (2006) in the context of yield curve modeling. The specification is tested on implied volatilities from the over-the-counter foreign exchange options market, where contracts with long expiries are actively traded and thus the term structure dimension of the surface should be very important. We first show that the proposed volatility specification can consistently and remarkably improve our ability to describe the surface on any given day. We then establish the economic relevance of the incremental information captured by our proposed specification by showing that it can produce more accurate forecasts of implied volatility that can support long-term profitable trading strategies in the absence of transaction costs.

Air pollution and stock returns in the US

Health related research documents that air pollution has negative mood effects. Experimental works in psychology relate bad mood to increased risk aversion. Studies in financial economics report an observed link between mood effects and stock market returns. This study therefore investigates whether the mood effects caused by air pollution can have economic implications. It examines the relationship between air pollution and stock returns using data from the Air Quality Index, and stock returns from four stock exchanges in the US. We find that air pollution is negatively related to stock returns, even when controlling for other variables. The relationship becomes weaker as the distance of the stock exchange from the polluted area increases. The results also indicate that air pollution may even affect local traders investing in securities exchanges located far from the polluted area. The findings imply that a profitable trading strategy can be constructed.

News Analytics for Energy Futures

We investigate how crude oil futures markets respond to positive and negative sentiment in news, as measured by the Thomson Reuters News Analytics. We measure the impact of the news sentiment on daily futures returns and on the fundamental factors of the forward curve evolution, such as the forward curve’s level and the slope. We define positive and negative news events as those days when the aggregated daily sentiment is in the top 10% quantiles of the corresponding sentiment distribution. We then relate these events to abnormal futures returns and to significant changes in the forward curve’s level and slope. We find that, for all maturities, positive resp. negative news events are accompanied by long periods of higher resp. lower than normal returns. These abnormal returns are observed already prior to the significant news events, suggesting that news are correlated with price momentum. Furthermore, after a negative news event occurs, returns continue decreasing at least for the subsequent 20 days. This is especially pronounced for nearby maturities, whose returns decrease by more than 3% on average. After a positive news event, returns increase on average by 2-3%. These effects are both statistically and economically significant. We also show a great asymmetry in the market’s behavior: although positive and negative events are both 10% of days, the negative events are accompanied by much greater losses than the gains surrounding positive events. We analyze the complex effect of news on the slope of the forward curve, and show that negative news increase the slope both in backwardation and contango markets. This means that contango deepens and backwardation flattens following a negative news event. Positive news have the opposite, albeit smaller, effect on the forward curve’s slope. Generally, the reaction to news is significantly more pronounced in contango than in backwardation market. The results of the analysis lay foundation for profitable trading strategies, based on taking a long/short position in oil futures of a fixed maturity immediately after a significant positive/negative news event. However, we expect such strategies to be quite risky. The analysis of news effects on the entire forward curve can be used to construct profitable (but much less risky) calendar spread trading strategies.

Option Implied Volatilities and Corporate Bond Yields: A Dynamic Factor Approach

This paper estimates dynamic factors from the term structure of credit spreads and the term structure of equity option implied volatilities, and it provides a comprehensive characterization of the dynamic relationships among those credit spread factors and equity volatility factors. The paper finds strong evidence that the volatility factors, especially the volatility level factor, Granger cause credit spread levels, confirming the theoretical predictions of Merton (1974) in a significantly richer and more nuanced environment than previously achieved. Simultaneously, the paper also finds evidence of reverse Granger causality from credit spreads to equity volatility, operating through the slope factors, consistent with the market microstructure literature, which finds that price discovery often happens first in bond markets. Hence the results extend both the corporate bond pricing literatures, deepening our understanding of stock and bond market interaction and suggesting profitable trading strategies.

Tactical allocation in commodity futures markets: Combining momentum and term structure signals

This paper examines the combined role of momentum and term structure signals for the design of profitable trading strategies in commodity futures markets. With significant annualized alphas of 10.14% and 12.66%, respectively, the momentum and term structure strategies appear profitable when implemented individually. With an abnormal return of 21.02%, our double-sort strategy that exploits both momentum and term structure signals clearly outperforms the single-sort strategies. This double-sort strategy can additionally be utilized as a portfolio diversification tool. The abnormal performance of the combined portfolios cannot be explained by a lack of liquidity, data mining or transaction costs.

The Shrinking Index Effect: A Global Perspective

The index effect, or the excess returns of a stock added to a leading index, is one of the most researched pricing anomalies in finance.Is the index effect shrinking? To answer this question, we study the index effect for headline indices of five of the biggest equity markets in the world: U.S. (S&P 500), Canada (S&P/TSX 60), Japan (Nikkei 225), U.K. (FTSE 100) and the Germany (DAX 30).We find that excess returns for index additions have diminished over the past five years. The median excess return of S&P 500 additions was 3.8% for the past five years, compared to 6.0% for the five years prior. The declining pattern is also observed in Nikkei 225, S&P/TSX 60 and DAX 30, but not the FTSE 100.The diminishing index effects may be attributed to several factors: First, the index effect has fallen victim to its own popularity. As more arbitrageurs have come in to the market, arbitrage profits have reduced. Second, changes in market structure and trading patterns of index funds have dented the index effect.The index effect may never vanish completely. But its days as a profitable trading strategy may be numbered. Alternative index-related profit opportunities involve trading index changes in the options market or trading index share changes.

A profitable trading and risk management strategy despite transaction costs

We present a new profitable trading and risk management strategy with transaction cost for an adaptive equally weighted portfolio. Moreover, we implement a rule-based expert system for the daily financial decision-making process using the power of spectral analysis. We use several key components such as principal component analysis, partitioning, memory in stock markets, percentile for relative standing, the first four normalized central moments, learning algorithm, and switching among several investment positions consisting of short stock market, long stock market and money market with real risk-free rates. We find that it is possible to beat the proxy for the equity market without short selling for 168 S&P 500-listed stocks during the 1998–2008 period and 213 Russell 2000-listed stocks during the 1995–2007 period. Our Monte Carlo simulation for both the various set of stocks and the interval of time confirms our findings.

Staying the Course: The Role of Investment Style Consistency in the Performance of Mutual Funds

While a mutual fund's investment style influences the returns it generates, little is known about how a manager's execution of the style decision affects portfolio performance. Using both returns- and holdings-based techniques to measure the consistency with which managers approach their investment mandates, we demonstrate that, on average, more style-consistent funds significantly outperform less style-consistent funds on a risk-adjusted basis. This result differs from portfolio turnover and expense ratio effects and is robust with respect to the period used to measure future returns. We also show that fund style consistency and the persistence of risk-adjusted performance over time are distinct influences and demonstrate the potential profitability of trading strategies based on their combined impact. We conclude that deciding to maintain a consistent investment style is an important aspect of the portfolio management process.