Saturday, June 24, 2006

How to Kill a Trending Market



One of the best ways of killing a trending market is to develop a tradable index for it. And if you really want to drive a stake in its heart, you develop multiple tradable indices.

Why?

The indices provide arbitrage opportunities, which mean that an increasing proportion of volume is devoted to keeping stocks in line with the index, index 1 in line with index 2, etc.

That's how you get the chart above, which tracks average volume and volatility in SPY from 2000 to the present. Note that volume in SPY has steadily risen to all time highs. Volatility, however, has steadily decreased from 2003 to the present, the recent uptick notwithstanding.

With the recent hyperexpansion of ETFs, this has important implications. Increased liquidity over time will bring a range of markets to the average stock trader that, to this point, have not been available. With that volume, however, may come trading patterns that make the market harder to trade with traditional momentum/trend tools.

In a recent study, I showed how the propensity to trend has been coming out of the S&P market on a long-term basis. If I'm right, this might be the future for those stock sectors and markets that attract significant attention from index players. Automated index arbitrage brings significant volume to markets, but it is not necessarily the volume that contributes to directional market trade.

4 comments:

Howard Lindzon said...

excellent thoughts and thesis. Love to see this over more markets to see if there is any real significance.

Brett Steenbarger, Ph.D. said...

Hi,

Thanks for the note, Howard. I have not studied the trend/volatility patterns in other asset classes, but I do find that they exist in the other stock indices as well: NASDAQ 100, small caps, etc.

Brett

Chester205 said...

Hi Brett - I read your article and found it very interesting but am confused about how this could effect ETF's like DIA for example. Why would there be buying and selling of the underlying stocks within the ETF? I can understand why there would be for a mutual fund index as buyers and sellers enter and exit the fund, but since the ETF's are traded like a stock (and I assumed a fixed number of shares are available for trading), I don't understand why there would be liquidation and a need to keep the stocks in line with the index once the ETF was set (except for when the underlying index changes it's components like the INDU just did). Would you shed some light? I'm new to all this and trying to learn. Thank you - Chester

Brett Steenbarger, Ph.D. said...

Hi Chester,

I'm not sure I understand the question, but arbitrage activity keeps the derivative product (ETF) in line with the underlyings (the stocks). You can see buying and selling among the component stocks; arb activity will keep the ETF in line--

Brett