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

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

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

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  1. Return reversals and the compass rose: Insights from high frequency options data Thanos Verousis (Swansea University) Owain ap Gwilym (Bangor University)

  2. The compass rose pattern architecture Conditions: • Sufficient price level volatility • Price discreteness • Small price changes Arithmetic derivation: (Crack and Ledoit, 1996 JF) (Szpiro, 1998 JBF)

  3. Are we able to increase returns’ predictability? • 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”

  4. 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

  5. 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

  6. 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

  7. 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

  8. 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?

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

  10. 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

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