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Detecting the lead–lag effect in stock markets: definition, patterns, and investment strategies

Author

Listed:
  • Yongli Li

    (Harbin Institute of Technology)

  • Tianchen Wang

    (Harbin Institute of Technology)

  • Baiqing Sun

    (Harbin Institute of Technology)

  • Chao Liu

    (Harbin Institute of Technology
    Northeastern University)

Abstract

Human activities widely exhibit a power-law distribution. Considering stock trading as a typical human activity in the financial domain, the first aim of this paper is to validate whether the well-known power-law distribution can be observed in this activity. Interestingly, this paper determines that the number of accumulated lead–lag days between stock pairs meets the power-law distribution in both the U.S. and Chinese stock markets based on 10 years of trading data. Based on this finding this paper adopts the power-law distribution to formally define the lead–lag effect, detect stock pairs with the lead–lag effect, and then design a pure lead–lag investment strategy as well as enhancement investment strategies by integrating the lead–lag strategy into classic alpha-factor strategies. Tests conducted on 20 different alpha-factor strategies demonstrate that both perform better than the selected benchmark strategy and that the lead–lag strategy provides useful signals that significantly improve the performance of basic alpha-factor strategies. Our results therefore indicate that the lead–lag effect may provide effective information for designing more profitable investment strategies.

Suggested Citation

  • Yongli Li & Tianchen Wang & Baiqing Sun & Chao Liu, 2022. "Detecting the lead–lag effect in stock markets: definition, patterns, and investment strategies," Financial Innovation, Springer;Southwestern University of Finance and Economics, vol. 8(1), pages 1-36, December.
    • Handle: RePEc:spr:fininn:v:8:y:2022:i:1:d:10.1186_s40854-022-00356-3
    DOI: 10.1186/s40854-022-00356-3
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    References listed on IDEAS

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    1. Jian Guo & Saizhuo Wang & Lionel M. Ni & Heung-Yeung Shum, 2022. "Quant 4.0: Engineering Quantitative Investment with Automated, Explainable and Knowledge-driven Artificial Intelligence," Papers 2301.04020, arXiv.org.
    2. Ana Monteiro & Nuno Silva & Helder Sebastião, 2023. "Industry return lead-lag relationships between the US and other major countries," Financial Innovation, Springer;Southwestern University of Finance and Economics, vol. 9(1), pages 1-48, December.

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