Can you predict the market?
Have you ever wondered whether you can predict where the market is going to close based on what it has done in the past? Perhaps you want to know where the Dow will close after a week of big moves up, or maybe you want to know where your favorite stock will go after a disappointing earnings release.
I was curious about the same thing. We all know that the efficient market theory tells us that you can’t predict future returns based on previous moves, but I was curious to see if there were any exceptions.
Image from jannoon028
My current favorite strategy is to trade credit spreads on the weekly S&P 500 (SPX) options. By selling credit spreads based on the highs, lows, trends, and momentum on any given Friday (and only on Fridays), I can take put myself in the position of taking advantage of short time exposure and the quick evaporation of any time value left in those options. This strategy works well, but I wanted to see if I could predict where the market will close based on moves during the week.
To see if there was any relationship between where the market closes on Fridays and what it does over the course of the week, I gathered the open and close prices for the S&P 500 for every trading day since July 2003 and started crunching numbers. Using market returns in a given time period, and returns on their respective Fridays, I calculated correlations and relationships for five key relationships:
- The relationship between Friday’s performance (Thursday’s close to Friday’s close) and the performance from Wednesday’s close to Thursday’s close
- The relationship between Friday’s performance (Thursday’s close to Friday’s close) and the performance from Thursday’s open to Thursday’s close
- The relationship between Friday’s performance (Thursday’s close to Friday’s close) and the performance of the previous week (Monday’s open to Thursday’s close)
- The relationship between Friday’s performance (open to close) and Friday’s open
- The relationship between Friday’s performance (Thursday’s close to Friday’s close) and Friday’s open
Results
Image from winnond
Not surprisingly, my results showed that there’s generally no crystal ball. In scenarios 1-4 above, there was almost no correlation between Friday’s performance and performance in the past. In fact, on Fridays the market only closed in the same direction as it did in the past about 50% of the time. So, in scenarios 1-4, it’s all a coin flip – exactly what we’d expect if the efficient market theory is true.
But, the same wasn’t true for scenario 5. Interestingly enough, when you compare how the market opens on Friday and how it performs on Friday as a whole, you’ll see an interesting pattern emerge. The correlation in this scenario was .58 – not super predictive, but not too bad. Even more telling, the market finished in the same direction that it opened about 65% of the time.
What does this mean?
Well, if the market opens up, chances are, it will close up. If it opens down, chances are, it will close down. Be careful, though. In scenario 4, I found that there was a bit of a reversal on Friday mornings after the open, so even though it may open or close, chances are, it will revert back a little bit.
For those that are interested, here are the actual numbers:
| When the market closes in the opposite direction… | ||||||||
| Scenario | Correlation | % of Fridays that end in the same direction as the corresponding time period in the prior week | Average difference in the S&P’s level when not closing in the same direction as prior week | 70th %ile | 80th %ile | 90th %ile | ||
| Scenario 1 | -0.083 | 52.07% | 9.85 | 12.1 | 15.32 | 21.1 | ||
| Scenario 2 | -0.067 | 51.21% | 7.68 | 8.9 | 12.1 | 18.0 | ||
| Scenario 3 | 0.058 | 54.27% | 9.78 | 11.3 | 14.1 | 20.3 | ||
| Scenario 4 | -0.177 | 48.76% | 7.52 | 8.5 | 11.7 | 18.1 | ||
| Scenario 5 | 0.583 | 65.01% | 6.16 | 7.5 | 9.5 | 16.0 | ||
How to trade it
These results don’t give us much to act on – until you get to your first Friday morning. Only scenario 5 gives us some sort of pattern that we can use, and fortunately for me, it goes right along with my strategy. Given this information, we know that the market will tend to close up on those Fridays when it opens up, and down when it opens down (albeit, there’s a slight chance it will see a bit of a reversal). Even when it doesn’t close the same way that it opens, there’s still an 80% chance that it will close within 10 points of where it closed on Thursday night.
So, with this knowledge, you could formulate some day trades. Probability is in your favor if you place a credit or debit spread in the same direction as the day’s opening trend. If you wanted to give yourself a safety buffer, you could even place the credit spread around 10 points away from the closing point of the previous Thursday.
No matter what you do, manage your risk and don’t get greedy. It can take a lifetime to build up your wealth, but only one bad trade to wash it away.
