3 – M4 L3b 03 Overnight Returns Possible Alpha Factors V2

From reading the introduction, we see that the authors refer to investor sentiment as the positive or negative views of investors, especially individuals who tend to cluster their orders around a market open. The authors also define overnight returns as the close to open returns and describe the following hypothesis. Individual investors may notice attention getting events and may then choose to trade on those events. Since many of them have day jobs, they may place trades aftermarket clothes that would be executed the following morning. The hypothesis continues to assume that these overnight trades may be subject to mean-reversion by the middle of that second day. Based on this, you may start thinking about how this can be useful as an alpha factor. Let’s say, a stock’s overnight returns are high. So, that morning, you see an increase in a stock’s open price relative to the previous day’s close. According to this hypothesis, the stock is overbought and we may expect a correction in a form of a drop in the price. So, if you calculate the overnight return of the stock, you can short the stock that same morning when the overnight return is high. However, that’s not the effect that we will look to capture here. There are ideas later in the paper that we will use to construct an alpha factor. Also, in the introduction, the authors state that they test for short-run persistence in overnight returns. This indicates some momentum in the overnight returns over a short term window. If we continue reading in section two titled sample, variable definitions, descriptive statistics, we can see that they’re interested in a window of one week or five trading days. They calculate the average daily close to open return over a week as a measure of the persistence or momentum in sentiments. Again, based on this information, you can think about how this weekly average momentum factor might be used in a theoretical portfolio. If according to the hypothesis, the weekly average close to open return for a stock is high and positive, we might want to buy more shares of that stock with the assumption that the positive returns will continue in the short run. Finally, the abstract also identifies a third possible factor. With the hypothesis that in the longer term, stocks with high overnight returns under perform. In other words, in a longer time window, stocks exhibit mean reversion. If we go to section five titled longer-term returns, the hypothesis based on other papers is that stocks that are more attractive to speculators and therefore see more near term positive returns may end up under performing over the next 12 months. However, this also is not the effect we will look to capture here.

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