Return reversals and the compass rose: Insights from high frequency options data

Thanos Verousis (Swansea University)

Owain ap Gwilym (Bangor University)

The compass rose pattern architecture

t

t

t

t

tt

tt

ttt

ttt

t

t

n

n

hn

hn

PP

PP

PPP

PPP

R

R 11

1

1

11

11

)(

)(

/)(

/)(

t

t

t

t

ttt

tt

t

t

P

hn

n

n

hnPhn

Phn

R

R1

)/(

/ 111

Conditions:– Sufficient price level volatility– Price discreteness– Small price changes

Arithmetic derivation:

(Crack and Ledoit, 1996 JF)

(Szpiro, 1998 JBF)

Crack and Ledoit, 1996 JF: “an artefact of market microstructure”

Lee et al. (2005, EJoF): “...may help in improving forecasts...”

Batten and Hamada (2008, EFMA):“may suggest [...] an arbitrage opportunity for some investors”

Are we able to increase returns’ predictability?

Return reversal architecture and predictability

Gosnell (1995, JBFA) “a price change in the opposite direction to the previous price change”

Linked with new information (Buckle et al., 1998 JBFA)

In a compass rose plot, reversals (continuations) are found in the NW and SE (NE and SW) quadrants

Where do we stand and the setup

Study occurrence/visibility of the compass rose pattern in options Leverage effect Price level effect

Lee et al (2005, EJoF): “the tick/volatility ratio is a determinant of the compass rose pattern”

Show return reversals embedded in the compass rose plot

Data Intraday LIFFE 28 firms (> 133m obs.)

Returns on options: Sheikh and Ronn (1994, JF): at-the-money, nearest-to-mature Bollerslev and Melvin (1994, JIE): stale pricing problem – asks UHF, 15-min, 30-min, trades

The compass rose in options contracts

WRT Crack and Ledoit, 1996 JF: The assumption of continuity is not valid

WRT Szpiro, 1998 JBF: formula is not universal

,Sk = Sk-1, Si = Si-1,

Since , then

Lee et al (2005, EJoF, p 103): “the pattern appears only if the tick/volatility ratio is above some threshold level”

The above implies that: The pattern’s visibility increases with decreasing volatility (ceteris paribus) Contracts with same tick/volatility ratios produce a similar pattern

Table 1: Ratio consistent when changes in frequency of observations… Quality is not an increasing function of the ratio Even at high tick/volatility, the ratio not a consistent measure

Figure 3: Ratio may give inconclusive results on the strength of the pattern

The compass rose and return reversals

At UHF, certain assets exhibit a “pattern within the pattern”

Explanations found in literature: Park (1995, JFQA): bid-ask bounce Christie and Schultz (1994, JF): speed of adjustment

Figure 6: control for duration

and the non-linearity?

Continued...

Buckle et al (1998, JBFA): news dissemination (local minima), scheduled macroeconomic announcements (global minima) and day trading strategies (global maxima)

3233343536373839404142

Time

Percentage

VariableExpected

SignCall Put

Intercept 53.67*** 56.83***

Pr-

4.96*** 4.55***

TS-

-3.00*** -2.70***

Liq-

0.02*** 0.01**

OD-

5.46*** 6.05***

CD+

1.10*** 1.07***

DMM-

-3.79*** -3.44***

TTM-

-0.02** -0.01

FV-

-2.10*** -2.42***

R-Square 0.10 0.09

No. of Obs. 54,235  54,410

Conclusions

Compass rose in options: non-linearities

Tick/volatility ratio consistent at high sampling frequencies Trading frequency key element Inconclusive results on the strength of the pattern Visual inspection only comparable measure

Return reversals embedded in the compass rose Market opening and news announcements Price discovery