Question

You discover a technical ‘anomaly’ in the US stock market. You find that stocks that go up X% or more 2 days in a row have an expected alpha of X/100% the following day (for example if a stock goes up 6% and 9%, then the next day its expected alpha is 0.06%).

Suppose stock A has a BID-ASK spread of 0.2%, and has gone up 10% and 15% percent in the last 2 days. What is your expected profit (in dollars) if you choose to implement your strategy and take a $1000 position in the stock for one day?

Answer 1

Generally, the market is considered as efficient is all returns are equal to the market returns and thereby representing a Zero alpha meaning the rate a stock earns over and above the normal returns of the market. However, due to anomalies, the same can be observed and riskless profit can be gained from the same as depicted in the given question.

The stock will earn the following increase in return as per the facts of the question:

Alpha will be the excess return over the market: 10/1000*100

Increase in Price of the stock 10%/100%*1000 = $10