Short-Term Reversal in Equities

Rank stocks by their return over the past week, buy the worst-performing decile, short the best-performing decile, hold one week, repeat. This is one of the oldest documented anomalies in equity markets — Jegadeesh (1990) showed it produced strong positive returns over the following week — and it is also a strategy that looks far more profitable on paper than any real fund can capture, because the mechanism that generates it is the same mechanism that makes it expensive to trade.

Overreaction and liquidity provision

Short-term reversal happens because prices sometimes move further than fundamentals justify over very short horizons — a large sell order forces a market maker or a distressed seller to unload shares, pushing the price down beyond where informed buyers are willing to step back in immediately, and the price partially recovers over the following days as liquidity providers absorb the imbalance and get paid for the risk of holding it. In this reading, short-term reversal is compensation for providing liquidity when few others will: the reversal trader is on the other side of someone else's forced or panicked selling.

Worked example. A mid-cap stock closes down 8% over five trading days on no news specific to the company, likely from a large institutional seller working through a position. A reversal strategy buys it at the Friday close. If a third of that move reflects temporary price pressure rather than new information, the stock recovers roughly 2.5–3% over the following week as the imbalance clears, and the position is closed for a gross gain of that magnitude. But the stock that just fell 8% is by definition currently illiquid — its bid-ask spread has likely widened, and buying into a name that just got dumped means paying a wider spread and probably some market impact getting in. If round-trip trading costs on a name like this run 40–60 basis points and the strategy is rebalanced weekly (dozens of round trips a year per position), costs consume a large fraction of the ~2.5% gross edge before it ever reaches a P&L statement.

What this means in practice, and what erodes it

High-frequency and market-making desks with genuinely low transaction costs (tight relationships with venues, rebates, minimal market impact from small size) can still harvest this edge; it's a large part of what classical statistical arbitrage and market-making books do. Retail-accessible or slower institutional implementations mostly cannot, because the moment a strategy needs to trade meaningful size in the same illiquid names everyone else's reversal signal also flags, the act of trading pushes costs up further. Crowding compounds this: when many funds run similar short-horizon reversal signals, they compete for the same liquidity-provision role, narrowing the spread available to any one of them.