Friday, April 18, 2008

Bandwagon Effects in the Stock Market

A little while back I posted about the increasing number of one-sided days in the stock market and how those are affecting traders. Yesterday I noticed another kind of one-sidedness: seven of the last nine trading sessions in the S&P 500 Index ($SPX) have closed either in the top or bottom quarter of their day's range.

This led me to examine more broadly the issue of how often stock indexes close near their day's highs or lows. If we divide each day's range into quartiles, then we would assume, over time, that a chance distribution would put 50% of market closes in the top or bottom quarter of the day's range and 50% in the middle two quarters.

That is not what we see in the data, however. Since July, 2007, two-thirds of all trading days closed either in the day's top or bottom quarter: 132 out of 200 days, to be precise. From January, 2000 through June, 2007, that ratio was 61% (385 out of 627 days).

If we tighten the criteria and divide each day's range into deciles, we can observe how often the market closes in the top or bottom 10% of its daily range. One would expect, by chance, that this would occur 20% of the time. Since July, 2007, however, it has occurred 77 out of 200 days: 38% of all occasions. From 2000 through June, 2006, we closed in either the top or bottom 10% of the daily range in $SPX 209 out of 627 days, or 33% of the time.

What we are seeing is that markets are closing near their day's highs or lows more frequently than we would expect by chance. This may reflect a bandwagon effect, in which traders and investors observe market movements during the day and don't want to miss out on them. This would lead them to buy rising markets and sell falling ones, creating late day strength or weakness. Regret and the fear of missing out on a market move would lead to increased trending behavior as the day progresses, creating a kind of one-sidedness to the trade.

This bandwagon effect, exaggerating market movements late in the day, tends to be unwound the next day. Going back to 2000 (N = 2082 trading days), we find the following average next day changes in $SPX as a function of the location of the prior day's close:

Prior Day Closes in Top Quarter of Range (N = 727): -.06% (343 up, 384 down)
Prior Day Closes in Middle Two Quarters of Range (N = 743): -.02% (381 up, 362 down)
Prior Day Closes in Bottom Quarter of Range (N = 612): .11% (357 up, 255 down)

What this suggests is that, once a bandwagon starts during the day, it tends to persist into the close. Fading one-sided days, particularly of late, has not been a fruitful endeavor for traders. Expecting bandwagons to persist into the next day's trade, however, has also not been profitable. It appears that traders segment their performance day by day, perhaps jumping aboard trends in an effort to finish their days on winning notes. By the close of the next day, however, any such bandwagon effect has been erased.


Why It's Difficult to be a Trend Follower

Markets and Trending


Ravi S Ghosh said...

My conclusion of the above observation would be:
1. Most people trade on trends rather than trading ranges, i.e, they bet on continuation of the trend rather than return to normalacy.
2. More often than not either bulls or bears dominate rather than both being equally strong. In other words, prices either tend to go up or go down instead of staying at the middle. Thats something like reinventing the wheel since we are betting on that very movement of prices. Aren't we? Had prices not gone up or done, financial markets would not have existed at all.

Wayne Mulligan said...

Interesting observations and data analysis...taking it to the next logical step, how can an investor use this information to profit?


Brett Steenbarger, Ph.D. said...

Hi Wayne,

Second half of the day trend following setups using tools mentioned on the blog (Market Delta, NYSE TICK) strike me as a trading strategy that would follow from the observations. I don't think an *investor*, however, can capitalize on this pattern to any significant degree (unless maybe to time execution).


FeirFactor said...

That's interesting.

As for implementation, couldn't you sell into strong days and buy weak days towards the end of the day if these moves tend not to hold the following day?

SSK said...

Hello Brett, thanks for the rejoinder. I think the NYSE tick chart is really great, a tool I wasnt using previously. There are many interesting relationships to time, price and volume delta within many timeframes within that data. Are you aware of any Asian indices that have something similar to the NYSE/S&P relationship? Thanks, Steve

bhh said...

Ironically, I just completed a similar study looking at using daily range & close to assist in filtering trades for EOD trend-following. The affects on expectancy for taking only trades who's close fell withing the top 25% of their daily range was disastrous.

AaronP said...


This is my first time posting, but your site has been part of my regular reading for some time now. I really enjoy it and keep up the good work.

I could be over thinking this, but isn't it to be expected that an outsized % of days prices end near the highs or lows? If you assume that prices take time to move, the farther out prices go in one direction means they have less time in the day to close "as expected" in a random distribution? An interesting analysis would be to look at the size of the day’s range and the distribution of the closing price. Perhaps the larger the range, the more prices closes towards the highs/lows. Another idea would be to look at what time of day highs and lows tend to be made. If most highs or lows are later in the day, this would support the idea that prices should close nearer to the highs and lows that we'd normally expect. What do you think?

Globetrader said...

One conclusion might be, that at least at the moment it does not pay to hold index futures or stocks overnight. While until this credit crises madness started we had nearly no intraday movement with big moves overnight, now we see very rewarding moves intraday, which tend to get faded or consolidated overnight. That means for me, we are in a daytraders, actually intraday swingtrader type of market, which does not reward holding overnight.
The kind of returns you could see in the past when holding the S&P overnight for a continuation move is just no longer there. I remember Brett posting a study about the big percentage moves the S&P made overnight compared to nearly flat behaviour when looking at intraday moves. I think that study would look different nowadays. Markets change and you should better change with them.

Brett Steenbarger, Ph.D. said...

Hi AaronP,

Great point; I've done research on when ES makes daily highs and lows and the extremes tend to cluster early and late in the day--