Positive‐feedback trading activity and momentum profits

Abstract

Purpose

The purpose of this paper is to examine positive‐feedback (PF) behavior and its relationship to momentum profitability and information uncertainty.

Design/methodology/approach

Using the behavioral function of rational traders and feedback traders, the authors jointly estimate the mean and conditional variance equations of the GARCH model to derive the positive‐ and non‐positive‐feedback coefficients, respectively. In each six‐month period, the number of PF stocks were then calculated as a fraction of the total number of stocks in that period. The authors then investigate whether day‐to‐day PF trading activities vary across different momentum portfolios by calculating the percentage of PF stocks in each decile portfolio.

Findings

This study finds that about 9.4 per cent of stocks exhibit PF trading activities and that these activities have a more profound effect on stocks with a higher level of information uncertainty. The finding shows that the percentage of stocks with PF trading is higher in the portfolios of extreme losers than in the portfolios of extreme winners. The evidence suggests that stocks exhibiting PF trading activities subsequently experience significantly higher momentum returns.

Originality/value

This paper presents evidence to test whether a relationship exists between short‐term PF trading and future momentum profitability. Since PF traders tend to chase price movements, PF trading is more likely to cause stock prices to further diverge from the firm's fundamentals and, therefore, give rise to stock return momentum. This phenomenon appears to be more profound in this study when there is a higher level of information uncertainty.

Citation

Shi, J., Chiang, T.C. and Liang, X. (2012), "Positive‐feedback trading activity and momentum profits", Managerial Finance, Vol. 38 No. 5, pp. 508-529. https://doi.org/10.1108/03074351211217832