Picking a Thorny Rose: Optimal Trading with Spread-Based Return Predictability

European Financial Management

63 Pages Posted: 25 Jul 2022 Last revised: 22 Dec 2023

See all articles by LinJun Feng

LinJun Feng

Renmin University of China - School of Finance

Ya Li

Hong Kong Metropolitan University

Jing Xu

Renmin University of China - School of Finance

Date Written: December 19, 2023

Abstract

Small stocks' time-varying spreads predict future return gap between small and large stocks. To optimally exploit such predictability, the investor captures current risk premium by purchasing at large spreads with substantially reduced turnover; uses an aim-in-front-of-the-target approach to trade-off between future risk premium and current transaction costs; and meets hedging demand at low costs. Strong interaction between transaction costs and return predictability leads to large losses from myopic trading. Greater variability of the spread is advantageous for investors who trade optimally but detrimental for investors who trade myopically. The spread-based return predictability significantly increases the investment value of small stocks.

Keywords: portfolio choice, transaction cost, bid-ask spread, liquidity premium

JEL Classification: G11, G12, C61

Suggested Citation

Feng, LinJun and Li, Ya and Xu, Jing, Picking a Thorny Rose: Optimal Trading with Spread-Based Return Predictability (December 19, 2023). European Financial Management, Available at SSRN: https://ssrn.com/abstract=4163240 or http://dx.doi.org/10.2139/ssrn.4163240

LinJun Feng

Renmin University of China - School of Finance ( email )

Ming De Main Building
Renmin University of China
Beijing, Beijing 100872
China

Ya Li

Hong Kong Metropolitan University ( email )

30 Good Shepherd Street, Ho Man Tin
Hong Kong

Jing Xu (Contact Author)

Renmin University of China - School of Finance ( email )

59 Zhongguancun Street
Beijing, 100872
China

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