Autocorrelation is a time-series phenomenon where a stock’s past and future returns are correlated. The presence of autocorrelation occurs mostly due to dependencies within the data and is also believed that momentum in the underlying might be caused by the autocorrelation in returns.
Without getting into complexity, autocorrelation can show if there is a momentum factor association with a underlying. For example, stocks that have hit a new 52–week high continue to make further gains over the following days show the presence of high positive autocorrelation.
Indian indices are most active around the derivatives contract expiration. But how does this impact price trends in the following days? Is there any meaningful pattern that can be tradable?
Most of us tend to trade directionally when the underlying has hit price extremes. But, how should we define “price extreme”? The threshold for me is one percent — which is one standard deviation of expiry day returns since 2009.
The strategy is to buy Nifty Index on the day of the monthly derivatives expiration if the expiry day return is above the threshold.
Backtesting & Assumptions
To test this concept, I performed a quick backtesting using Python from March 2009 to December 2018 with the following assumptions:
1. Backtesting assumes zero friction.
2. Trade was entered at the end of the expiry day if the expiry day return was above the threshold.
3. Position was held for the next 7 calendar days.
4. Trade was left untouched and all statistics were recorded between entry and expiry levels.
Backtesting Results
{‘Total Trades’: 19, ‘Positive Trades’: 16, ‘Negative Trades’: 3, ‘Average Return’: 1.46, ‘Maximum Return’: 5.43, ‘Minimum Return’: -2.54, ‘Maximum Return Date’: ‘May, 28, 2009’, ‘Minimum Return Date’: ‘Sep, 29, 2011’, ‘Hit Ratio’: 84.21}
Of the total 19 signals, 16 resulted into profit with an average return of 1.46% per trade. Thus, buying Nifty Index on a positive one standard deviation move on expiry day had a positive expectancy of 84%.
The data show that a positive return tends to be followed by positive expectation. Thus, presence of such momentum phenomenon makes derivatives trading even more exciting.
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