Will the market be volatile today?

Perhaps no question is more common over the communal coffee pots at my trading firm than: "Think it's going to move today?" For short term traders, volatility is one measure of potential opportunity. An S&P emini market that swings freely in a 15 point range will offer, on average, more risk and reward than one that is caught in a 4 point range. My experience working with traders is that most have a dominant trading style. Some are Traders, trying to ride directional moves in the market. Others are Faders, selling into strength and buying into weakness. As a rule, low volatility markets are more range bound than high volatility markets and thus are traded best by Faders. High volatility markets offer more breakouts from ranges and are best capitalized upon by Traders. When we're standing around the coffee pot before the open, what we're really trying to figure out is whether the market is likely to be kind to Faders or Traders.

One of the best indications of coming volatility is the overnight movement of the market. How the major averages move between the market close and their open the next day reflects a variety of factors, such as overnight news events, trading in Asia and Europe, and pre-opening economic reports and earnings reports. When the market moves a great deal overnight, it means that important global and macro forces are probably at work. Such forces do not dissipate at the mere ringing of the opening bell in New York, impacting trade the next day.

During the bull market from March 12, 2003 to the present (N = 720 trading days), the correlation between the size of the price change from yesterday's close to today's open in the S&P 500 Index (SPY) and the current day's price range has been a positive and significant .33. For the NASDAQ 100 Index (QQQQ | Quote | Chart | News | PowerRating), the correlation between the overnight move and the next day's range is .32. The correlation for the Dow Jones Industrial Average (DIA | Quote | Chart | News | PowerRating) has been .36, but the correlation for the Russell 2000 Index (IWM | Quote | Chart | News | PowerRating) has been only .19. It appears that events overnight have a greater impact on large cap stocks than small caps.

To give an idea of the magnitude of the effect, when the market opens up or down more than .5% from its previous day's close (N = 89), the day's trading range has exceeded 1% on 70 of the 89 occasions. When the market opens up or down less than .05% from its previous day's close (N = 98), the day's trading range has exceeded 1% on only 42 of the 98 occasions. A large move at the open thus suggests roughly a 75% chance of a daily range in excess of 1%. A small move at the open suggests a less than 50% chance of a range exceeding 1%.

That one piece of information may be helpful in keeping you and your trading buddies from fading volatile moves or playing for breakouts in slow markets. At the very least, it will give you something to talk about over the morning coffee.

P.S. For you traders of individual equities, I've posted a few volatility correlations on my free research site.

Brett N. Steenbarger, Ph.D. is Associate Clinical Professor of Psychiatry and Behavioral Sciences at SUNY Upstate Medical University in Syracuse, NY and author of The Psychology of Trading (Wiley, 2003). As Director of Trader Development for Kingstree Trading, LLC in Chicago, he has mentored numerous professional traders and coordinated a training program for traders. An active trader of the stock indexes, Brett utilizes statistically-based pattern recognition for intraday trading. Brett does not offer commercial services to traders, but maintains an archive of articles and a trading blog at www.brettsteenbarger.com and a blog of market analytics at www.traderfeed.blogspot.com. He is currently writing a book on the topics of trader development and the enhancement of trader performance.