BF W11

behavioral trading strategy

3 assumptions

  1. investors make behavioural mistakes
  1. your trading should be opposite to the mistake

greedy when others are afraid, and afraid when others are greedy

  1. in the long run, price will converge to the fundamental value

used by large institutional investors with great capital (hedge/mutual funds) NOT retail investors

BECAUSE this strategy needs quantitive trading (quat trading)

use research to find anomaly

anomaly: abnormal returns that can't be explained by traditional risk factors -> contradict traditional finance

click to edit

5 steps

Step 1

identify the anomaly that you wanna use in your behaviour trading strategy

connect anomaly to behavioral biases or theories

step 2

sort all investments in the same market by the anomaly factor

step 3

set investment into 10 deciles based on the anomaly factor

step 4

create the strategy

key: identify which investments in which decile is most over/undervalued -> short/long the investment in these deciles

step 5

test the (systematic) risk of the portfolio

ex: salient effect: investors are attracted to stocks with salient upsides -> overvalued and earn low subsequent returns. Opposite to salient downside stock

ex: salient effect

ex: system 1 -> consume less energy -> limited attention -> availability bias + representative bias -> salient effect

quantify anomaly factor using closing price of the stock

use datanalysis premium rmit to calculate return from historical data of stock price in medium term (1m<x<12m)

ex: process

sort close price from high->low

choose 200 top and 200 bottom firms after sorting, ignore firms in the middle -> to represent the salient effect

ex: long the firms in lowest decile (least salient) and short firms in highest decile (most salient)

ex: see slides w11

ex: test whether the difference between firms in highest decile and lowest decile is derived from risk

ex:test at least whether market risk drives your result

calc raw return in future and market adjusted return (=raw retrun-market return at the same period) to control market risk

NOTE: no need to calculate in asm, only describe