Sunday, March 15, 2009

Predicting Trending and Non-Trending Markets: A Direction for Research

My recent post suggested that the intraday NYSE advance-decline line ($ADD) offers a useful perspective on whether the day is shaping up as a mixed, range day or a one-sided trending day. Because an awareness of the emerging day structure is key to trading tactics--whether you'll trade or fade strength or weakness--few research questions are as important to the active trader. Nonetheless, I've seen no solid research on this topic in the writings I've encountered.

Let's frame the research challenge more broadly: If we consider indicators A, B, C...etc. at points of time X, Y, Z...etc. during the morning hours, which indicators most accurately predict trending and non-trending markets earliest during the market day?

Say, for example, that indicator C at time X is the best gauge of whether or not we'll have a trending market, significantly correlating with price movement from time X to the market close. It would then make sense for a daytrader to sit out the period from the market open to time X, waiting for the noise to sort itself out before an educated estimate could be made relative to the issue of day structure.

Armed with this information, a trader could then establish tactics for the trading day and use his/her feel for markets to aid in the execution of those tactics.

Here's a simple example: If we go back to late September, 2008 (which is as far as my intraday data set for the indicator goes), we find that the opening value of the advance-decline indicator ($ADD) correlates with the final, closing value by about .30. That means that 9% of the variance in the closing value of $ADD is accounted for by its opening value.

If, however, we look at the value of $ADD after the first 15 minutes of trade, that correlation with the closing advance-decline value jumps to .63. That means that 39% of the variance in the closing value of $ADD is accounted for--a significant jump. Indeed, if the first 15 minutes in $ADD are positive, the average closing value of $ADD is +675. If the first 15 minutes are negative, the average closing value of $ADD is -1063.

These findings are suggestive and illustrative only. Crucial questions remain: How do the indicators correlate with an actual price-based measure of trending/non-trending? Will a combination of indicators prove more predictive (or predict more early) than a single indicator? Are the indicator values related to trending/non-trending in a linear or non-linear manner?

Good posts offer fresh answers to tough trading questions. The best posts, however, offer fresh questions and directions for trading. Personally, I think this is the best post I've written in quite a while.