Wednesday, April 19, 2006

Question Common Wisdom!

Note: Tomorrow (Thursday, 4/20) at 4 PM CT I will be doing a free online lecture for Woodie's CCI Club. Their chat room link is on their home page.

A while ago, I got another one of those breathless advertisements announcing how the currency markets offer such great trending instruments. Since I work at a professional trading firm and have watched both the currency markets and traders trade those markets, my doubts got the better of me. I conducted an analysis of the Euro/Dollar futures and found that, in fact, the contract is quite poor as a trending instrument. What happens is that the contract has episodes of extremely high volatility, which create very large gains and losses. On a chart, it looks as though the market is trending up or down. The actual period-to-period movement, however, is quite choppy--not at all trendy.

It pays to question common wisdom.

So here's another piece of common wisdom that periodically comes my way: The S&P 500 Index tends to close near its high or low for the day. Notice that this is one way of saying that, on a day timeframe, the S&P behaves in a trending fashion. My doubts on that topic are already a matter of public record on my personal site. Still, let it not be said that I lack an open mind. I decided to consult the data.

Since January, 1999 on SPY (N = 1834 trading days), we have closed in the top 10% of the day's range on 146 occasions. We've closed in the bottom 10% of the day's range on 143 occasions. Note that by chance, we should have closed in the top and bottom 10% of the range approximately 183 times each.

Over that same time period, we closed in the top 20% of the day's range 261 times and in the bottom 20% of the day's range 235 times. By chance, we would expect to close in the top and bottom 20% of the range about 367 times each.

Stated otherwise, we close in the middle 60% of the day's range 1338 out of 1834 times or 73% of the time. If anything, this suggests a tendency to *not* close at extremes.

Since January, 2005 (N = 326), we closed in the top 20% or bottom 20% of the day's range 81 times. This means that we closed in the middle 60% of the range 75% of the time.

It pays to question common wisdom.