Friday, November 17, 2006

How You Can Lose Money Buying In An Uptrend

It's not enough to get market direction right, if your timing is all wrong.

Many markets (like the current stock indices) can form an uptrend by having occasional strong up days punctuated with periods of consolidation. If you buy after the strong days, you can get chopped up in the consolidation. If you sell the consolidation, you get run over by the bullish days. Markets can exhibit non-trending, reversing qualities on a short time frame and yet form a trend (i.e., conform to a trend line) over a longer period.

Here's an eye-opening finding. Since 2004 (N = 718 trading days), we've had 385 days in which we have been profitable from open to close. Following such a positive day, the next two days in the S&P 500 Index (SPY) have averaged a loss of -.06% (185 up, 200 down). That is weaker than the average two-day gain of .03% (387 up, 331 down) for the entire sample.

Conversely, when we've been down from open to close (N = 333), the next two days in SPY have averaged a gain of .21% (196 up, 137 down)--considerably stronger than average.

In other words, if you just look for selling after an up day session and buying after a down day session, you would have had an edge--despite the fact that the market has been in an overall uptrend since 2004.

The trend is not necessarily your friend if you're buying highs in a rising market. For the day timeframe trader, there's been no trending effect from day to day. Indeed, there has been a tendency toward reversal. This has also occurred at intraday time frames. The average open to close change in the S&P 500 Index since 2004 has been essentially zero.

For daytraders and short swing traders, we've basically had no bull market in the last 2+ years. Whether we're in a bull or bear market in the big picture matters not at all if that trend doesn't filter down to the time frame you're trading. Failing to understand that has cost daytraders a lot of money.


b hong said...

Thanks Brett
An excellent and timely reminder. Another way of saying this is to not get caught up in the emotion of one big day and enter impulsively. Stick with your trading plan and your charts.

cpptrader said...

Dr. Steenbarger,

Great post! I have come across this in my own trading where I am consistently taking trades against the general trend and thinking that I am playing a dangerous game, yet at the same time I consciously am aware that I am following my rules.

Thanks for putting a quantification to this - I need to look into it further.


Brett Steenbarger, Ph.D. said...

Thanks for that observation, B Hong. It is very easy to lose context and get swept up in recent action. Reviewing the big picture is indeed a good antidote to that problem!


Brett Steenbarger, Ph.D. said...

Hi Matthew,

I think you have it right. There is a lot of mean reversion at short time frames in the stock indices and it's not at all a dangerous game to fade market moves--especially when you see volume and participation not confirming those moves. Knowing how the market responds to strength and weakness *at your time frame* is key. Thanks for the comment--