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
(
WM |
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.