Friday, February 27, 2009

Combating Recency Effects in Trading

This morning's trade offered a nice example of how an understanding of historical market patterns can help put a brake on cognitive biases that lead to poor trading decisions.

We moved sharply lower during pre-opening trading hours, breaking below the multi-day trading range. I noted in my morning Twitter comments (free subscription via RSS) that an important issue for the day was how we traded around the market's opening price.

The recency effect is a cognitive bias in which we overweight the most recent events and allow them to unduly color our future expectations. Understandably, traders caught up in the pre-opening weakness might anticipate further downside market action early in the day, particularly given the downside breakout.

At such times, I like to check my biases against actual market history. Since 2007 in the S&P 500 Index (SPY), for example, the correlation between overnight market moves and moves during the day session is only .06. In other words, these function as largely independent trading periods. Indeed, we've had 59 occurrences of SPY opening more than 1% lower than its previous day's close; the market's subsequent day session was up 27 times, down 32 times, for an average loss of -.21%. That compares with an average loss of -.06% (236 up, 247 down) for the remainder of the sample.

So, yes, particularly during a period of lower market prices, there can be downside follow through to overnight weakness. This is hardly a significant edge, however. Knowing that a different category of traders participates in the day session vs. the overnight helps us avoid the recency bias of assuming that overnight moves will continue into the day.

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