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Asian Review of Financial Research Vol.25 No.2 pp.203-246
A Study on the Profitability of the Trading Strategies Using Past Returns
Sangwhan Kim Professor, Department of Economics, Chungbuk National University
Key Words : Momentum,Contrarian Strategy,Price Continuation,Price Reversal,Overreaction


This paper studies the profitability of the contrarian trading strategies in the Korean stock market in an attempt to provide some insights into why the trading strategies generate the abnormal profits. It has been reported in most foreign literature that the momentum strategies (i.e. buying stocks with high returns over the previous 3 to 12 months and selling stocks with poor returns over the same time period) earn significant profits for the following 3 to 12 months. Contrary to these empirical facts on foreign stock markets, many Korean academic papers reported that contrarian strategies (i.e. buying losers and selling winners) are significantly profitable in the Korean stock market. Yet no research effort has been made to explicate this strange phenomenon in the Korean market. The first objective of this paper, therefore, is to explain why this surprising phenomenon happened in Korea. Secondly we attempt to determine the sources of the expected profits of the trading strategies that use the past information. In contrast to the previous literature using the circumstantial evidence on the causes of the profitable trading, we directly look into the profits of the trading strategies as suggested by Lo and MacKinlay (1990) and Conrad and Kaul (1998). Adopting this approach we divide profits of trading strategies into two components: one that results from time-series predictability in security returns and the other component that arises due to cross-sectional variation in the mean returns of the securities contained in the portfolio. The significance of the time-series components (namely, overreaction and lead-lag effect) is interpreted to support the behavioral explanations on the trading profits, while significant cross-sectional variation in the mean returns indicates the risk-based explanations of the traditional asset pricing theory. We empirically show that contrarian strategies are able to generate profits only in the pre-crisis period. After the Asian crisis, momentum strategies earn significant profits just like in most foreign markets. At first, it may sound puzzling how the completely opposite strategies can remain significantly profitable in the consecutive periods in the same market. But these opposing outcomes in the Korean market do make sense if we consider the substantial structural changes which have taken place in the Korean investors' behavior. It is suspected that the profitability of contrarian strategies in pre-crisis period is due to the dominant retail investors. For example, the individual investors traded more than 80 percent of the total amount in 1992. They are evidently inclined to buy cheap losers and sell high-priced winners, which leads to the profits of contrarian trading. Ever since the Korean market was opened to foreign investors in the aftermath of the 1997 crisis, the foreign investors and domestic institutional investors have quickly dominated the stock market trading. Their share of the trading amount jumped to 35 percent in 2005 and more than 45 percent in 2008. The dominance of institutional investors is suspected to be the main reason for the profitable momentum strategies. These explanations are also supported by Khil, Kim, and Sohn(2006), who report that the institutional investors and foreign investors show the positive feedback trading behavior while retail investors are chasing the negative feedback trading behavior in the Korean market. For the robustness check on the J-T strategies, we also test the profitability of contrarian trading strategy using the weighted trading approach. The trading strategy in Jegadeesh and Titman (1993) uses the stocks in the lowest past return decile and in the highest return decile to form the winners and losers. But in the weighted trading strategies, every stock in the sample is traded, with their weight measured relatively to the average return of all stocks. In the whole sample period, the weighted strategy does not generate significant profits. But the contrarian weighted trading did create profits in the pre-crisis period and significant losses in the post-crisis period. This outcome supports the previous findings on the performance of the J-T contrarian strategy. The analysis of the sources of trading strategies' profits found that the investors' overreaction is a significant factor, implying that the behavioral biases of the traders account for most of the trading strategies' profits. However, the cross-sectional difference of individual stocks' mean returns (reflecting the risk of each stock) also contributes to the profitability of trading strategies. This risk-based explanation indicates that the profit-generating trading strategies are compatible with the traditional asset pricing theory. The significance of both over-reaction and risk-based differentials in the Korean market implies that the profitability of trading strategies does not support or deny the behavioral or rational investment theories. If the former factor is larger than the latter, then the momentum strategies will generate profits, while if the over-reaction dominates, then the contrarian profits will be found significant. These results show that trading strategies' profits can not be explained by either behavioral theory or traditional risk-return theory alone but by both of them. This conclusion is in line with that of Daniel, Hirshleifer and Subrahmanyam (2001), claiming that both investors' irrational behavior and systematic risks determine the asset prices.
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