Enhancing the profitability of lottery strategies

Abstract

Recent studies show that lottery strategies, buying non-lottery type stocks and shorting lottery-type stocks, earn positive returns on average. This study examines whether the profitability of lottery strategies is predictable, and, more importantly, whether such predictability is exploited to enhance their performance. As a predictor, we employ the speculation sentiment index recently developed by Davies (forthcoming) based on observable trading activity in the leveraged Exchange Traded Funds market. We find that the profitability of lottery strategies is predictable by the lagged speculation sentiment index both in sample and out of sample. We propose active trading rules that are implementable in real time and dynamically switch the long and short legs on the lottery strategies exploiting the predictive power of speculation sentiment. The proposed dynamic strategies significantly outperform the passive strategies, yielding significant economic gains for investors with certainty equivalent return gains of 7.41%–26.35% and increases in annualized Sharpe ratios of 0.37–1.15.