Friday, May 26, 2006

How Optimistic Are Traders When Markets Rise?

Thursday's market rose steadily through the day with solid buying, as noted in the Weblog. As an aside, I should note that that's not necessarily a positive thing--or at least hasn't been recently. Since March, 2003 (N = 811 trading days), we've had 204 days in which SPY has risen by .50% or more in a single day. Two days later, SPY has averaged a gain of only .03% (102 up, 102 down)--no upside edge at all. On the remainder of trading occasions, SPY has averaged a two-day gain of .13% (337 up, 270 down).

But what happens when the market rises by .50% or more and traders lose their optimism? I measure this very simply by tracking equity call volume changes from day to day. When SPY has risen strongly in a single day and call volume has expanded (N = 149), the next day averages a gain of .02% (86 up, 63 down). But when SPY has risen strongly in a single day and call volume has dropped (N = 55)--as happened on Thursday--the next day averages a loss of -.09% (22 up, 33 down).

Markets have tended to correct strong one-day gains, but this tendency is particularly pronounced when those gains have not been accompanied by commensurate speculative interest, as demonstrated by the actions of equity options traders. In my next post, we'll look at trader pessimism as markets decline.