Saturday, September 30, 2006

The S&P 500 Index and Its Multiple Personality

Here is the 2003-2006 bull market from three perspectives. The red line is the one we're most familiar with: it is the S&P 500 Index (SPY). The bullish and trending yellow line represents the cumulative price change of the S&P 500 Index outside of normal market hours (overnight). The blue line, which represents only a very modest gain over the entire period, is the cumulative price change of the S&P during the normal day session from open to close.

The correlation between the blue line (Daytrading Index) and yellow line (Nighttrading Index) is .04. What happens to the S&P during normal day hours is wholly independent of what happens to it after the close and before the open. The S&P truly has a multiple personality.

There are several implications to this breakdown:

1) Analyzing the Index as a whole (SPY) to derive patterns for daytraders may be faulty methodology. To the extent that researched patterns include--and are dominated by--overnight price changes, they portray opportunity that the daytrader would never realize;

2) Trend traders operating in the day timeframe would be well advised to extend their holding periods. Their trading methods might better take advantage of the trending component of the overnight market;

3) Because over half of all NYSE volume is program trading, the day session is dominated by arbitrage. Much of the market's directional activity occurs after the close and before the open, which is when many economic reports are released and when many influential world markets (currency, oil) are operating.

Notice that I am not saying that the day timeframe lacks opportunity. Rather, I'm suggesting that daytrading has not been offering a trending opportunity, and it is offering opportunity that is independent of what occurs in the market overnight.

To capture this opportunity, might it make sense to analyze patterns within the Daytrading Index, rather than in the S&P 500 Index itself? While the Daytrading Index is not a true trading index and traders are unlikely to replicate its performance by precisely buying the open and selling the close each day, analyses of historical patterns in the Daytrading Index would provide more accurate alerts to directional movements than analyses that include time periods during which the trader will never hold positions.

One other interesting implication of all this: With the advent of free trading, might it make sense for a trader to actually trade the Nighttrading Index as an instrument? Someone who bought the close and exited at the open each day would have done well, sans commissions, during the past several years.

I will be pursuing Daytrading and Nighttrading Index patterns in my own research and report here on this blog and in the Trading Psychology Weblog.