Are Strong or Weak Daily Closes Predictive?
Posted in Technical Trading
August 3, 2010
When the stock market close is strong (weak) relative to the daily range, does it indicate pent-up buying (selling) demand? Should a trader follow the trend of the close the next day, position for a reversal or look for a better indicator? To investigate, we compare the position of the daily close for a broad market index relative to same-day high and low to the next-day return for the index. We also compare the five-day and ten-day average relative closes to the index return for the next five and ten days, respectively. Using daily high, low and close levels of the S&P 500 Index for the period 7/15/83 (the earliest without obvious errors available) through 8/2/10 (6,823 trading days), we find that:
The following figure depicts the average close of the S&P 500 Index relative to its daily high and low for the entire sample period, 55% above (45% below) the daily low (high). The standard deviation of the relative close is 34%, indicating that the relative close is fairly dispersed across its potential range.
How does the value of the relative close relate to the index return the next day?
The following scatter plot relates the daily (close-to-close) return on the S&P 500 Index to the prior day relative close. There is no obvious relationship between the two series. The Pearson correlation for the entire sample is -0.02 and the R-squared statistic is 0.000, indicating that prior day relative close has no power to predict daily return.
To check for non-linearity in the relationship, we consider returns by decile of relative closes.
The next chart summarizes average daily returns for the S&P 500 Index by decile of prior day relative closes. While the relationship is not systematic across deciles, the lowest decile stands out with a relatively strong average daily return after days when the index closes very near its low for the day. The two lowest deciles have notably higher standard deviations of returns than the other deciles.
A trader seeking to exploit the lowest decile would have to anticipate the relative close by enough to trade at the close, and the return statistics may not overcome trading frictions.
Might the average relative close over the past five trading days be predictive for the index return over the next five trading days?
The next scatter plot relates the 5-day return on the S&P 500 Index to the average relative close over the preceding five days. For this plot, we use results for every fifth trading day (1,363 observations) to eliminate overlap of measurement intervals. The Pearson correlation for the relationship is -0.06. The R-squared statistic is 0.01, suggesting that past average relative close explains only 1% of future returns.
Again, to check for non-linearity in the relationship, we consider returns by decile of average relative closes.
The next chart summarizes average 5-day returns for the S&P 500 Index by decile of average relative closes over the preceding five trading days. While the relationship is not systematic across deciles, the lowest decile again stands out with a relatively strong average return after days when the index has persistently closed very near its daily lows. Lower deciles have higher standard deviations of returns than upper deciles.
There is some indication that persistently closing near the middle of the daily range is bearish.
Might the average relative close over the past ten trading days be predictive for the index return over the next ten trading days?
The next scatter plot relates the 10-day return on the S&P 500 Index to the average relative close over the preceding ten days. For this plot, we use results for every tenth trading day (681 observations) to eliminate overlap of measurement intervals. The Pearson correlation for the relationship is -0.05. The R-squared statistic is 0.002, suggesting that past average relative close explains less than 1% of future returns.
Again, to check for non-linearity in the relationship, we consider returns by decile of average relative closes.
The final chart summarizes average 10-day returns for the S&P 500 Index by decile of average relative closes over the preceding ten trading days. While the relationship is not systematic across deciles, the middle deciles stand out with relatively weak average returns after days when the index has persistently closed near the middle of its daily range. The lowest decile does not stand out in this case. Standard deviations of returns do not vary systematically across deciles, perhaps because of the lower subsample size.
In summary, evidence from simple tests indicates that stock market closing level relative to the daily range may convey a little information about near-term returns, with very weak closes bullish for daily returns and closes persistently near the middle of the daily range perhaps bearish for weekly/biweekly returns. Scarceness of opportunities and trading frictions work against economic significance.
