Momentum and reversals in Taiwan index futures returns during periods of extreme trading imbalance Erin H. Kao Department of Finance, Ling Tung University, Taichung 408, Taiwan, ROC article info abstract Available online 27 November 2010 The study analyzes the relation between a trading imbalance metric that captures data observable by investors, and future momentum and reversals in Taiwan index futures returns. Standard regression analyses do not show any significant dynamic relations between daily index futures returns and the trading imbalance, regardless of whether the trading imbalance metric is lagged, contemporaneous, or leads the index futures return. However, when the analyses are focused on periods with extreme trading imbalances I find that the daily index futures returns exhibit significant reversals following periods of extreme (low) trading imbalances and low returns. I also find some evidence of residual momentum in consecutive daily index futures returns following periods of extreme (high) trading imbalances and high returns. Trading simulation, directional accuracy, and market timing tests show these effects to be economically significant, even after accounting for transaction costs. © 2010 Elsevier Inc. All rights reserved. JEL classification: G14 G13 G12 G11 C53 Keywords: Momentum Reversals Imbalance Trading test 1. Introduction Existing research examining the relation between returns and measures of order imbalance mostly focuses on mature markets (e.g., Chordia, Roll, & Subrahmanyam, 2002; Chordia & Subrahmanyam, 2004; Chordia, Roll, and Subrahmanyam, 2005; Cao, Hansch, & Wang, 2009). In addition, prior studies that examine imbalance metrics mainly emphasize equity markets, such as stock indexes (e.g., Chordia, Roll, & Subrahmanyam, 2002, 2005) or individual stocks (e.g., Chordia & Subrahmanyam, 2004; Bailey et al., 2009; Tsai, 2010). The objective of this paper is to examine momentum and reversals in daily Taiwan index futures returns during periods of extreme trading imbalance. The Taiwan index futures market is interesting because it has been existing since 1998 with a reasonably high daily trading volume that mirrors many mature futures markets but yet it has a 7% daily price limit and many emerging futures market characteristics. A number of studies have examined the price limit effect in the stock market. For instance, Kim et al. (2008) suggest that price limits delay the price discovery process and Huang et al. (2001) find that overreaction is delayed by price limits. Nonetheless, few studies study the economic significance of applying futures market trading rules in an emerging market. A study of the Taiwan futures market enlightens the understanding of the progress of its futures trading. I focus on daily returns and analyze the dynamic relation between index futures returns and the calculated trading imbalance measure. Specifically, this paper examines the economic significance of executing trades that use a trading imbalance metric. The importance of trading activity in price formation is clear. Price and quantity are the fundamental building blocks of any theory of market interaction. However, prior studies that examine return anomalies or the predictability of returns have focused mainly on past returns. The implications from trading activities have received far less attention. Lo and Wang (2000) conclude that trading activity is fundamental to a deeper understanding of economic interactions, and they suggest that the most pressing issues International Review of Economics and Finance 20 (2011) 459–467 E-mail address: erinkao@mail.ltu.edu.tw. 1059-0560/$ – see front matter © 2010 Elsevier Inc. All rights reserved. doi:10.1016/j.iref.2010.11.019 Contents lists available at ScienceDirect International Review of Economics and Finance journal homepage: www.elsevier.com/locate/iref