Saturday, December 16, 2006

Three Lessons From The Daytraders' Index

Above is a chart of the S&P 500 Index (SPY) since 2004 (red) and an index that I call the Daytraders' Index (blue). The Daytraders' Index consists of the cumulative changes of the market's move from open to close. So, in essence, the Daytraders' Index is a chart of SPY with the effect of the overnight (close to open) action eliminated.

What we can see clearly is that the Daytraders' Index looks very much like a detrended SPY. We are almost exactly at the point in 2006 that we were at the start of 2004, even though SPY is more than 30 points (300 S&P futures points) higher.

There are several important lessons we can gather from the Daytraders' Index:

1) A directional bias in the S&P 500 Index has not helped the daytrader. The daytrader's market has not had a systematic, trending bias, even though we've been in a bull market. The daytraders should not necessarily become more bullish when the S&P 500 Index breaks to new highs, because--in an important sense--that is not the market they are trading.

2) Daytraders need to trade the patterns relevant to their market. Useful historical price patterns may be present in the Daytraders' Index that are obscured by the market's overnight action. Conversely, price patterns over multiple days in the S&P 500 Index may not benefit the daytrader if a large part of the price gains from those patterns occur in the overnight market. Developing an idea from a daily barchart, for example, won't necessarily benefit a daytrader because, even if it is correct, the anticipated movement may not happen at the trader's time frame.

3) The market has been paying a handsome risk premium to traders willing to assume overnight risk. By avoiding overnight exposure, daytraders also insulate themselves from the opportunity of participating in the bull market. Rather than simply grow larger in response to profitability, it could make sense for the daytrader to diversify by time frame and capture some of the market's risk premium. By properly sizing overnight vs. intraday positions, the trader can easily manage the risk of overnight exposure and cultivate a new source of alpha.

In a very real sense, the S&P 500 Index is an amalgam of two different trading markets. One is a relatively trendless day session and the other is a trendy overnight market that responds to international market movements and premarket economic news. In my upcoming posts, I will explore some of the historical patterns in the Daytraders' Index and how they might be relevant to both intraday and swing traders.