Trading volume and prediction of stock return reversals: Conditioning on investor types' trading

Abstract

We show that contrasting results on trading volume's predictive role for short‐horizon reversals in stock returns can be reconciled by conditioning on different investor types' trading. Using unique trading data by investor type from Korea, we provide explicit evidence of three distinct mechanisms leading to contrasting outcomes: (i) informed buying—price increases accompanied by high institutional buying volume are less likely to reverse; (ii) liquidity selling—price declines accompanied by high institutional selling volume in institutional investor habitat are more likely to reverse; (iii) attention‐driven speculative buying—price increases accompanied by high individual buying‐volume in individual investor habitat are more likely to reverse. Our approach to predict which mechanism will prevail improves reversal forecasts following return shocks: An augmented contrarian strategy utilizing our ex ante formulation increases short‐horizon reversal strategy profitability by 40–70% in the US and Korean stock markets.

Full text

RESEARCH ARTICLE
Trading volume and prediction of stock return reversals:
Conditioning on investor types' trading
Numan Ülkü
1
| Olena Onishchenko
2
1
Institute of Economic Studies, Charles
University, Prague, Czechia
2
Department of Accountancy and
Finance, University of Otago, Dunedin,
New Zealand
Correspondence
Numan Ülkü, Institute of Economic
Studies, Charles University, Opletalova 26,
CZ‐110 00 Prague, Czechia.
Email: numan.ulku@gmail.com
Funding information
Accounting and Finance Association of
Australia and New Zealand; University of
Otago; Commerce Research Grant ‐2015
Abstract
We show that contrasting results on trading volume's predictive role for short‐
horizon reversals in stock returns can be reconciled by conditioning on differ-
ent investor types' trading. Using unique trading data by investor type from
Korea, we provide explicit evidence of three distinct mechanisms leading to
contrasting outcomes: (i) informed buying—price increases accompanied by
high institutional buying volume are less likely to reverse; (ii) liquidity sell-
ing—price declines accompanied by high institutional selling volume in insti-
tutional investor habitat are more likely to reverse; (iii) attention‐driven
speculative buying—price increases accompanied by high individual buying‐
volume in individual investor habitat are more likely to reverse. Our approach
to predict which mechanism will prevail improves reversal forecasts following
return shocks: An augmented contrarian strategy utilizing our ex ante formu-
lation increases short‐horizon reversal strategy profitability by 40–70% in the
US and Korean stock markets.
KEYWORDS
forecasting short‐horizon reversals in stock returns, trading of investor types, trading volume
1|INTRODUCTION
Short‐horizon reversals, first documented by Lehmann,
(1990), Atkins and Dyl, (1990), and Bremer and Sweeney,
(1991), are one of the main predictable patterns in stock
markets. The likelihood of reversals following stock return
shocks is related to the trading volume accompanying the
return shock. The performance of short‐horizon reversal
strategies significantly varies when conditioned on vol-
ume. However, there are contrasting empirical results
and theoretical predictions on trading volume's role: rever-
sals are more likely following high volume in some cases
and low volume in others. Explanations for the contrasting
outcomes have been only partly established, and backed by
only indirect evidence of the mechanisms proposed.
High trading volume represents mass action in the
stock market. Its potential association with the likelihood
of subsequent reversals would imply systematic mecha-
nisms, driving the behavior of crowds and leading to pre-
dictable outcomes. Therefore, a clearer understanding of
trading volume's role in forecasting subsequent reversals
in stock returns is warranted.
The series of contrasting findings on trading volume's
predictive role in seminal empirical studies starts with
Conrad, Hameed, and Niden, (1994), who find on a sam-
ple of NASDAQ stocks that reversals are more likely fol-
lowing higher volume. In contrast, on a sample of large‐
cap NYSE‐AMEX stocks, Cooper, (1999) reports that
reversals are more likely following lower volume.
Llorente, Michaely, Saar, and Wang, (2002) find that
reversals are more likely following higher volume among
large‐cap stocks, against Cooper's, (1999) result. All these
findings conflict with Stickel and Verrechia's (1994) ear-
lier result that reversals are more likely following lower
Received: 8 October 2018 Accepted: 13 February 2019
DOI: 10.1002/for.2582
582 © 2019 John Wiley & Sons, Ltd. Journal of Forecasting. 2019;38:582–599.wileyonlinelibrary.com/journal/for