Convergence to Market Efficiency of Top Losers
28 Pages Posted: 19 Jan 2010
Date Written: January 12, 2010
We use top losers to examine convergence speed of order imbalance on stock return since order imbalance has been claimed to be a state variable in cross sectional return. We found that significance of order imbalance coefficients decreased with increasing time interval (5, 10 and 15-min), indicating evidences on convergence to market efficiency. We also employ a time varying GARCH model to examine the relation between order imbalance and volatility. Again, the significance of order imbalance coefficients shows a decay pattern which also supports convergence to market efficiency hypothesis. We suspect that small firm effect plays a role in convergence. However, our empirical results do not suggest an expected negative relation between order imbalance coefficients and market capitalization.
Finally, we developed an imbalance-based trading strategy and made profit from these daily top losers. We short sell seller-initiated order imbalances and buy back buyer-initiated order imbalances. We try many scenarios in testing our strategy. All of them outperformed buy and hold strategy. In order to explain the profitability of order imbalance based strategy, we examine the causal relationship between return and order imbalance. We find that order imbalance is a good indicator of price discovery under our nested causality framework.
Keywords: market efficiency, order imbalance, top loser
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