Thursday, January 19, 2006

Overnight Moves and Next Day Volatility

I recently submitted an article to Trading Markets that looks at the relationship between the size of the overnight moves in the major indices and the trading range the next trading session. It turns out that for such averages as the S&P 500 Index (SPY), the NASDAQ 100 Index (QQQQ), and the Dow Jones Industrial Average (DIA), the correlation between the size of their move from close to open and the subsequent high-low range is in the order of .33. When the overnight move is greater than .50%, the market has a trading range that exceeds 1% over three-quarters of the time. When the overnight move is less than .05%, the market trades in a range greater than 1% less than half of the time.

Interestingly, the Russell 2000 correlation is only about half that of the Dow. Overnight events may well impact large cap issues more than small caps. It is also interesting to look at correlations for individual stocks. Many stocks, such as MSFT (.30), AAPL (.27), and IBM (.23) have correlations similar to the indices. Others, such as XOM (.07) show little relationship between the magnitude of overnight moves and trading range the next day. This may be because XOM is impacted more by contemporaneous movement in the oil market than by overnight events.

Using overnight movement and current volume to predict near-term volatility has been extremely helpful in my trading, as volatility is a predictor of whether markets will break out of ranges vs. revert to mean trading prices. This appears to be a strategy that can work for individual equities as well as indices.