Sunday, October 01, 2006

Are Technical Indicators Relevant for Daytraders?

In my last post, I observed that the behavior of the S&P 500 Index during its day hours (open to close) was quite different--and independent of--its behavior during night hours (close to open). As I noted on my Trader Performance page, this calls into question market analyses utilized by daytraders that incorporate overnight data.

Unfortunately, overnight information is embedded within many traditional technical indicators utilized by daytraders. These include, not only price series, but such measures as TRIN, advances/declines, and oscillators covering multiple days.

Above we have a chart that features three advance-decline lines and SPY, going back to early March, 2003. The dark blue line is a traditional advance-decline line derived from the 17 stocks in my Institutional basket. These issues are highly liquid stocks that represent the major sectors that are part of the S&P 500 Index. My historical studies have found that these stocks track the SPX quite well.

The yellow line is an advance-decline line derived solely from the overnight performance of the stocks. In other words, we are cumulating the gap between the prior day's close and the current day's open. Note the persistent upward trend--precisely the same pattern we saw with the "Nighttrading" S&P Index from the previous post.

The red line is an advance-decline line built solely upon the day session performance of the stocks. Here we are cumulating the open to close performance of the stocks. Observe that we have a rather steady downward trend. This is the same pattern we saw with the "Daytrading" S&P Index in the last post.

The traditional advance-decline line is basically an amalgam of the two lines. It does not reflect actual stock performance experienced by a daytrader. For that, we might need to use an advance-decline measure drawn solely from day session (open to close) data. Similarly, any effort to assemble overbought-oversold measures for the market should draw upon day session performance: the actual market being traded by the daytrader. It may well be that technical indicators so constructed would do a better job than traditional measures at identifying tradable patterns for the daytrader.

Perhaps the following example makes the issue clearer. Let's say that I live in an area of New Mexico at high altitude. You wish to visit me and ask me what kind of clothes you should pack for the climate. I tell you that the average temperature is 60 degrees F., and you accordingly pack a light sweater and jeans. When you arrive, however, you find that daytime temperatures hit the 90s and nights get into the 30s. The average temperature did not help you pack; it obscured important differences between day and night.

By looking at average price performance across entire days, daytraders can similarly obscure important day and night differences. What does it matter that "the trend is up" or "the market is strong" if the trend has no statistical bearing on the hours that you are trading--or, in the case of the advance-decline numbers--a slightly *negative* correlation (-.22)?

And if your goal is to capture trending behavior in the markets, is daytrading an appropriate strategy? Does closing positions at the end of the day lower risk, or does it reduce reward?