G19 - General Financial Markets: OtherReturn

This study explores the effect of the gambler's fallacy on stock returns. I hypothesize that if during a number of consecutive trading days, a stock's return is positive (negative), then due to the gambler's fallacy, at least some of the investors may believe that the stock's price "has" to subsequently fall (rise), and thus, to increase their willingness to sell (buy) the stock, resulting in negative (positive) abnormal market-adjusted stock returns. Employing a large sample of daily stock price data, I was able to document that following relatively long sequences of positive (negative) stock returns, abnormal stock returns are on average significantly negative (positive), indicating the existence of the price pressure towards the return sign reversal. Moreover, the magnitude of the effect is stronger for longer return sequences. The effect is found to be more pronounced for smaller and more volatile stocks, and is robust to other relevant company - and stock-specific factors.

In the present study, I explore interday correlations between open-to-close and opening stock returns. Employing intraday price data on all the stocks that were S&P 500 Index constituents during the period from 1993 to 2013, I find that stock returns in opening trading sessions systematically tend to be higher following days with relatively low (either negative, or lower than the same day's market) open-to-close returns. Moreover, I explicitly document the tendency of opening stock returns to be reversed (to change their sign) following previous day's open-to-close returns. This kind of price behaviour seems to contradict stock market efficiency, and may be potentially interpreted as stock price 'corrections' following their 'deviations' from the underlying values caused by noise trading during the continuous trading sessions. Based on this finding, for the sampling period, I construct two different daily-adjusted investment portfolios based on the opening trading sessions and involving a long position in the stocks on the days when their opening returns are expected to be high and a short position in the stocks on the days when their opening returns are expected to be low. Both portfolios are found to yield significantly positive returns, even after accounting for trading commissions, providing an evidence for practical applicability of the documented pattern in opening stock prices.