Short-Term Residual Reversal

Abstract

Conventional short-term reversal strategies exhibit dynamic exposures to the Fama and French (1993) factors. We develop a novel reversal strategy based on residual stock returns that does not exhibit these exposures and consequently earns risk-adjusted returns that are twice as large as those of a conventional reversal strategy. Residual reversal strategies generate statistically and economically significant profits net of trading costs, even when we restrict our sample to large-cap stocks over the post-1990 period. Our results are inconsistent with the notion that reversal effects are the result of trading frictions or non-synchronous trading of stocks and pose a serious challenge to rational asset pricing models.

Keywords: short-term reversal, dynamic risks, residual returns, trading costs, market efficiency

JEL Classification: G11, G12, G14