A Practical Algorithm To Detect Superexponential Behavior In Financial Asset Price Returns

Lynch, Christopher and Mestel, Benjamin (2022). A Practical Algorithm To Detect Superexponential Behavior In Financial Asset Price Returns. International Journal of Theoretical and Applied Finance, 25(6), article no. 2250026.

DOI: https://doi.org/10.1142/s0219024922500261

Abstract

To assist with the detection of bubbles and negative bubbles in financial markets, a criterion is introduced to indicate whether a market is likely to be in a superexponential regime (where growth in such a regime would correspond to an asset price bubble and decline to an negative bubble) as opposed to “normal” exponential behavior typified by a constant rate of growth or decline. The criterion is founded on the Johansen–Ledoit–Sornette model of asset dynamics in a bubble and is derived from a linear fit to observed data with a nonlinear time transformation with parameters distributed uniformly in their permitted ranges. Making use of expected values rather than the underlying distribution, the criterion is straightforward and efficient to compute and can in principle be applied in real time to intra-day markets as well as longer timescales. In some circumstances, the criterion is shown to have certain predictive qualities when applied to a portfolio of stocks, and could be used as input into algorithmic trading strategies. A simple strategy is described which is based on market reversion predictions of a portfolio of stocks and which in back-testing generates notable returns.

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