Thursday, September 25, 2008

Day and Night Sessions: This Bear Isn't Nocturnal

I sat down with a young day trader before the market open and asked his strategy for the morning session. "I'm bearish," he explained. "The markets have all been down overnight."

"Do you know what the correlation is between the overnight change in the market from close to open and the change in the day session?" I asked innocently. He shook his head, seemingly surprised that someone would actually ask a question pertaining to data. "It's -.08 since 2007," I explained. "What happens overnight is not related to what happens during the day."

Our young trader was unusually naive when it came to his short-term trend following, but the fact remains that many short-term traders find their opinions colored by what happened overnight. In reality, these function as independent markets: what happens overnight is not predictive of what happens during the trading day.

A nice illustration of this independence is captured in the chart above. I created two indexes, both set to a value of 100 at the start of 2007. The first index (blue line) simply adds the SPY points from close to open to a running cumulative total. This is the "Night Market". The second index (pink line) adds the SPY points from open to close to a running total. This is the "Day Market".

Since 2007, the Night Market has gained 9.4 SPY points (the rough equivalent of 94 S&P 500 Index futures points). During that same time, the Day Market has lost 30.23 SPY points (about 302.3 S&P 500 Index futures points). For all practical purposes, the entire bear market during 2007 has occurred during the trading day; not during overnight trade.

But if these markets are truly independent, might we be able to best predict what will happen during the day by limiting historical investigations to previous day sessions? Could we predict what is likely to happen overnight by running studies on recent night sessions? There's plenty of room for original and interesting research by segmenting market days. More to come...