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Another Overnight Return Puzzle

 November 20, 2012 05:24 PM


An interesting fact of returns is that all of the stock returns since 1993 are from overnight returns. Here are the total returns using only Close-Open (overnight) vs. Open-Close (intraday). The intraday returns  are basically flat over the past 20 years

That's a curiosity  because 2/3 of the risk of stocks is from their intraday returns--measured by beta or volatility--so if return is compensation for risk, it doesn't seem consistent with that theory. However, there is further nuance I discovered that I haven't seen anywhere else. If you take all the tickers, the top 1000 non-etfs over the past 2 years, and rank them by prior daily volatility, and then look at their overnight returns, you see that volatility is strongly positively correlated with subsequent overnight returns, which then reverse over the next day session.

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So it appears that cross-sectionally, volatility receives a positive overnight risk premium, a negative intraday one.

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I couldn't figure out a way to make money off this, obviously. Note that if the average price in this sample is $43, making 0.15% generates 6 cents. Sounds great, but actually the returns are more concentrated for the lower-priced stocks, generating a return very close to the spread, ticker-by-ticker.

 While I think this pattern retains because it is too small to arbitrage, it is interesting residual pattern. I think it is best explained by something like this: high vol stocks are targets of intraday trading. This demand is generally positive, and so what you have are returns being depressed at the end of day from day traders selling and closing their positions, returns at the beginning of the day pushed up by the day traders opening positions (generally buying).

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