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

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