Saturday, May 06, 2006

Three Pieces of Market Wisdom

Here are three pieces of market wisdom that I hope will hold you in as good stead as they have served me:

1) The market provides its greatest edges following unusual recent market occurrences;

2) To determine your edge, investigate what the market has done in the past following such unusual occurrences;

3) To investigate what the market has done in the past following such unusual occurrences, investigate past time periods that have been similar to the present period. Don't use bear market data to investigate an event occurring in a bull market, etc.

Following up on a comment from Paul, who by the way has an excellent blog himself, I'd like to illustrate these principles.

Friday's response to the economic news was unusual. We opened on SPY higher than the highest high of the past five days. That has only occurred 57 times since March, 2003 (N = 799 trading days).

To determine if there was an edge after such a robust open, I looked at those 57 occurrences and found that the market, from the strong open to the close, averaged a loss of -.20% (27 up, 30 down). This is much weaker than the average open to close change of .02% (425 up, 374 down) for the sample overall.

But, wait. I noticed that 30 of the 57 occurrences took place in 2003 alone. That was the most robust period of the bull market, so it makes sense that we'd have a number of strong opens. But that was also the least typical part of the bull market, because of the higher volatility and trending during that time.

So, in accordance with the third principle, we look at only those occurrences of opens that are above the high from the previous five days since 2004 (N = 27). Lo and behold, we find that the average change from open to close was .07% (18 up, 9 down). And, from the open to the *following* day's close, we averaged a strong gain of .30% (18 up, 9 down)--much stronger than the average open to next day's close of .08% (438 up, 361 down) for the sample overall.

There are two lessons here:

1) Look for your edge in places where other traders aren't looking: when unusual events are occurring, but might be recognized as unusual at the time.

2) When you think you've found your edge, delve deeper. Sometimes the edge you think is there has gone away and, more recently, has been replaced by a very different pattern.

On my personal site tonight, I will post an entry to the Trader Performance page that elaborates some of these issues.