Are You Trading Predictably?

The authors find predictable patterns in stock returns. Stocks whose relative returns are high in a given half hour today exhibit similar outperformance in the same half hour on subsequent days. The effect is stronger at both the beginning and the end of the trading day. These results suggest that strategically shifting the timing of trades can significantly reduce execution costs for institutional traders. Anecdotal evidence suggests that some institutional traders concentrate trades at particular times of the day. For example, index funds may execute market-on-close orders to minimize tracking error relative to their benchmarks. Active managers may choose to hand trades to the trading desk at particular times of the day. In addition, trading algorithms that imply particular time-of-day trading patterns under certain assumptions have been proposed. A separate literature suggests that flows of funds to institutional managers are autocorrelated and that institutional trading is highly persistent—that is, institutional investment managers tend to buy or sell the same stocks on successive days. These two observations (time-of-day trading patterns and autocorrelated fund flows) suggest the existence of time-of-day patterns in both volume and order imbalances. If these patterns were fully anticipated by traders, however, one would not expect time-of-day patterns in stock prices. But we found persistent patterns in stock returns: Stocks whose relative returns are high in a given half hour today tend to exhibit similar outperformance in the same half hour on subsequent days. Although the effect is stronger at the beginning and the end of the trading day, it exists throughout the day. This periodicity is also stronger for small-cap stocks, but it exists for both large and small companies. The magnitude of the return pattern is sizable relative to several components of transaction costs, including commissions and effective spreads. The return patterns that we documented are consistent with investors’ predictable trading patterns. At a minimum, randomizing trades, rather than trading predictably, should help investors avoid buying high and selling low. More strategically, shifting trades to certain periods can substantially reduce execution costs for institutional traders.