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.

7 comments:

Wcw said...

That's pretty neat.

That said, if you check out the same price data back to 1993, it looks like the glory days of the overnight premium were the late-'90s. The last two years have been good as well, but less so. Here, I made a little chart of it.

It's pretty back-of-the-envelope, but it does look like taking the overnight beta risk has been a winner much of the time, and has rarely been a loser for very long. Wouldn't have been much consolation if you were long futures overnight on 10. September 2001, though.

Brett Steenbarger, Ph.D. said...

Thanks, WCW, for that excellent historical perspective. No question that, over the long haul, the market has rewarded the assumption of overnight risk. With position sizing and risk management, there's no reason an intraday trader can't branch out and harvest some of those returns.

Brett

Paulo de León said...

It would be helpfull if you could elaborate of your trendiness index. I track that index since you mentioned months ago. If you take a look at the trendiness measure of the ES, is registering some extreme readings, that is we are in a very trendiness market.
It needs to cool down a little bit, that is choppy action expected to bring down the trendiness reading.

Brett Steenbarger, Ph.D. said...

Hi Paulo,

That's an excellent observation and suggestion. Trendiness is relative to the time period being measured, but there's no question that, on a day-to-day, week-to-week basis, we've seen quite an uptrend since the July lows.

Let me see if I can study trendiness on a longer time frame and conduct a little historical investigation. I appreciate the idea--

Brett

Brandon Wilhite said...

Dr. Brett,

This may sound like an obvious question...but how would a day trader looking to take on some overnight risk go about his position sizing / risk management? It doesn't seem right to me to make the bet, say, 1% per trade regardless of holding time. Somehow, I think time needs to be taken into account here. Maybe normalizing the risk taken over an average week of time? This is an important question that I have never seen adequately addressed...and I've looked. I don't know why, but trading literature rarely accounts for the element of time when discussing p/l, risk, and other considerations.

Brandon

Brett Steenbarger, Ph.D. said...

Hi Brandon,

Great question; thanks. You can study the average size of market moves for various holding periods and adjust position size accordingly. Thus, for example, my overnight holds are 1/3 the size of my day positions, because the variability in returns in about 3x larger. That way, on average, my swing trades add to P/L, but do not wipe out days worth of intraday profits when they go the wrong way!

A thorough presentation of position sizing can be found in Ralph Vince's books.

Brett

Brandon Wilhite said...

Dr. Brett,

That's kind of what I had in mind. Thank you for pointing me to this resource...I'll check it out.

Brandon