Contrarian strategies and investor overreaction under price limits

Penny stocks are also called “egg-dumpling” stocks in Taiwan’s stock market, meaning that the price of a penny stock is similar to that of an egg or a dumpling, which has a price around three New Taiwan Dollars. Penny stocks are considered to be highly speculative and prices are likely to be manipulated.

It should be noted that contrarian strategies in this study refer to buy up-hit (sell down-hit) stocks today and then sell up-hit (buy down-hit) stocks tomorrow rather than to buy and sell simultaneously.

Recognizing the bid-ask spread constitutes a large portion of the transaction costs, TSE has continued to adjust the minimum tick size to reduce investors’ trading costs. Based on the minimum tick size and the trading price, the estimated bid-ask spread in trading Taiwan’s stock falls between 0.1% and 0.3%. The bid-ask spreads are estimated for both up-hit strategies and down-hit strategies. Furthermore, there is the possibility that the price of a limit-hit-not-lock stock reaches its limit but moves away quickly. This study assumes that the empirical result is not affected significantly by this phenomenon since an investor should be able to sell up-hit (buy downward) stocks at upward (downward) price limits easily because other investors are eager to buy up-hit (sell down-ward) stocks at upward (downward) price limits. Thus, it should be noted that our result would slightly overestimate the investment returns by employing the proposed limit-hit methodology.

The rationale for these categories is based on all of the publicly traded stocks in Taiwan’s stock market during 2006 (the last year of the study period). Approximately one-third of the total stocks had capitalizations less than 1.5 billion NTD, one-third had capitalizations between 1.5 and 5 billion NTD and one-third had capitalizations greater than 5 billion NTD. For the turnover grouping, we employ 2% and 5% as pre-specified cut-off points for turnover. As robustness checks, when the pre-specified cut-off points are moderately adjusted, the results remain basically the same. Thus, the choices of the cut-off points appear to be suitable.

These three categories are selected because of the unique composition of Taiwan’s output. Because high technology industries dominate, the break-down into tech, non-tech, and banking sectors appears to be appropriate.