Tuesday, April 04, 2006

When Days Are Flat: What Comes Next?

Here's a followup on the volatility theme, with a shout out to Paulo de Leon, whose comments on the postings are always insightful. What we're doing is looking at the open-to-close movement of SPY as a fraction of the day's high-low range. Very positive or very negative values show markets closing near their highs or lows for the day; values near zero indicate very little net movement on the day. The sample extends from March, 2003 to present (N = 777).

When the day's movement as a fraction of the day's range has been within plus or minus 10% (N = 80), the next three days in SPY have averaged .33% (48 up, 32 down). This compares favorably with the average three-day gain for the sample overall (.18%; 455 up, 322 down).

When I broke down the low net movement days in half based upon the day's volatility (range), however, a pattern emerged. When the market was volatile but closed near its open (N = 40), the next three days averaged a gain of .56% (27 up, 13 down). When the market was nonvolatile and closed near its open, the next three days averaged a gain of only .09% (21 up, 19 down).

Flat performances on the day thus have a different meaning based on the day's volatility. Non-volatile markets that are flat from open to close appear to lead to subnormal returns in the near term. Flat but volatile markets have much more bullish near-term prospects.

10 comments:

Paulo de León said...

Today´s was an example of an eficient day, ratio otc over htl of the day was high, after a very ineficient day yesterday.......tx

Brett Steenbarger, Ph.D. said...

Yes, I might take a look at whether efficient days are followed, on average, by inefficient days. That would be interesting. I'll also look at short-term outcomes following efficient days. Thanks for your observations, Paulo.

Brett

John Wheatcroft said...

This is interesting and something I've been using for some time in my own work. I learned it from a japanese text (translated) regarding candlestick analysis some years ago.

A new subject = earnings season is fast approaching again. There is a study that suggests that stocks begin going up a few days before the announcement when the number is going to be good and continue the move after the announcement. The converse is also held - they start going down a couple of days before a bad number announcement and continue that move as well. This seems to me to have some potential for predictive power.

Have you done any work in this area?

Brett Steenbarger, Ph.D. said...

Hi,

I haven't researched this personally, but there is much on the topic of investor underreaction to earnings news in the behavioral finance literature.

Brett

Paulo de León said...

Maybe the article on first half hr of trading might be related to this topic......can the 1st hr of the day predict if we are in an eff. or ineff. day? i will check this.....

Brett Steenbarger, Ph.D. said...

Excellent research question, Paulo. If you can predict whether the coming day will be inefficient or efficient, you'd basically have an indicator to tell you whether to trade in a countertrend or short-term trend following style. Needless to say, that would be very valuable information.

Brett

D TradeIdeas said...

Sorry in advance to ask what may appear as a novice question, but, isn't a tautology to say that a stock that closes near its open? The close is therefore where the stock opens unless a gap is present. Am I missing something?

Brett Steenbarger, Ph.D. said...

Hi,

Sorry for the conclusion. We're looking at where the stock opened for the day and where it closed at the end of that same day. A stock that closes near its open has shown little net movement during the day session.

Brett

D TradeIdeas said...

Thanks for the clarification. Here is a strategy based on your recent findings on volatility. It's based on the premise you've mentioned before that if the broad markets do not present ideal trading patterns, individual stocks certainly can.

Flat is a Relative Term

Best,
D

Brett Steenbarger, Ph.D. said...

Thanks, David. Finding individual issues that display superior volatility and trending even as the market is flat strikes me as a promising methodology. That's why monitoring volume patterns within the day across stocks and sectors is so effective.

Brett