An Anatomy of Trading Strategies

TLDR

The article applies a single unifying framework to analyze the sources of profits across a wide spectrum of return‑based trading strategies in the literature. The authors employ this framework to evaluate the profitability of 120 return‑based trading strategies implemented in the literature. Less than half of the 120 return‑based strategies examined generate statistically significant profits, with momentum strategies most profitable over medium horizons and contrarian strategies yielding significant returns only over long horizons during 1926–1947, while cross‑sectional variation in individual securities’ mean returns largely explains these profitability patterns and dampens long‑horizon contrarian gains.

Abstract

In this article we use a single unifying framework to analyze the sources of profits to a wide spectrum of return-based trading strategies implemented in the literature. We show that less than 50% of the 120 strategies implemented in the article yield statistically significant profits and, unconditionally, momentum and contrarian strategies are equally likely to be successful. However, when we condition on the return horizon (short, medium, or long) of the strategy, or the time period during which it is implemented, two patterns emerge. A momentum strategy is usually profitable at the medium (3- to 12-months) horizon, while a contrarian strategy nets statistically significant profits at long horizons, but only during the 1926–1947 subperiod. More importantly, our results show that the cross-sectional variation in the mean returns of individual securities included in these strategies play an important role in their profitability. The cross-sectional variation can potentially account for the profitability of momentum strategies and it is also responsible for attenuating the profits from price reversals to long-horizon contrarian strategies.