The profitability of equity trading strategies

Rights statement
Awarding institution
  • University of Strathclyde
Date of award
  • 2018
Thesis identifier
  • T14829
Person Identifier (Local)
  • 201377327
Qualification Level
Qualification Name
Department, School or Faculty
  • 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 explained by stages of the business cycle. The relationship between value premium and investors' sentiment is consistent with the aggregate level, i.e.investors' sentiment is unable to explain the value premium of any of the industries. Finally, in Chapter 4 this thesis investigates if strategy that takes a long position on high solvency stocks and a short position on low solvency stocks can generate abnormal returns. Solvency is the ability of firms to cover their financial obligations. The high solvency firms are those firms with sufficient cash flows (orbalance) to cover their debt obligations while low solvency firms refer to firms that are unlikely to meet their debt obligations. The profitability of this strategy is called the solvency premium. The findings of this thesis show evidence of the solvency premium in the short-horizon but it reverts to solvency discount in the long-horizon. When the three-factor model is applied to control for risk, the solvency premium disappears. This suggests the solvency premium can be explained by risk. Further analysis, however, shows that after controlling for risk, the solvency premium exists in economic contraction and disappears during economic expansion. The solvency discount, inversely, is observed only during economic expansion. When the investors' sentiment factor is incorporated into the three-factor model, the positive and significant coefficient of investors' sentiment is observed. This suggests that investors' sentiment is also relevant in explaining solvency premium, i.e. high investors' sentiment leads to higher solvency premium. This thesis shows that three styles of investing techniques can generate superior returns (i.e. conventional contrarian trading strategy, value versus growthtrading strategies, and corporate solvency based trading strategy). However, momentum trading fails to generate any significant return. The findings benefit both individual and institutional investors to identify the stocks that are likely to generate superior returns and allocate their funds efficiently. These styles still exist until the market is more efficient relative to these styles and superior returns cannot be earned(Cao, 2011). These styles, then, disappear.
Advisor / supervisor
  • Tang, Leilei.
  • Paudyal, Krishna.
Resource Type
Date Created
  • 2018
Former identifier
  • 9912593990702996