Why short-term trading is counterintuitive

All traders pay attention to price change, but should they also be looking at the patterning of that change? Does *how* a market moves from one point to another make a difference in its future movement?

In a recent post to my blog, I looked at strong 60-day periods in the market and showed how it is not just the trend of price change, but its trajectory, that leads for those moves to persist. This post will focus on short-term moves of five days going back to 2004 (N = 697 trading days).

During that time, we've had 258 occasions in which the S&P 500 Index (SPY | Quote | Chart | News | PowerRating) has been up over the last five sessions and up over the most recent session. Three days later, SPY has averaged a loss of -.03% (130 up, 128 down). That is weaker than the average gain of .09% (387 up, 310 down) for the entire sample.

When the previous five sessions have been up, but the most recent trading day has been down (N = 133), the next three days in SPY average a gain of .04% (74 up, 59 down)--a bit weaker than average, but not so weak as the dual up periods.

When the previous five sessions in SPY have been down, but the latest day has been up (N = 119), the next three days in SPY have averaged a gain of .15% (68 up, 51 down), somewhat better than average.

When the last five sessions are down *and* the most recent trading day is down (N = 187), the next three days in SPY average a gain of .25% (115 up, 72 down), handsomely above average.

These data fit nicely with the findings of Larry Connors and Conor Sen in their book "How Markets Really Work", which found that returns are better after short-term weakness rather than short-term strength.

The results also suggest that market returns are patterned in a manner that is precisely the opposite from the pattern of human expectations. If we see something rise during the past day and also during the past five days, it is human nature to look for the trend to be our friend and continue into the next several days. Conversely, if the market is down today and has been down over the past week, we naturally consider the market weak and expect further price softness.

But what happens is precisely the opposite.

The psychology of short-term trading begins with the simple realization that the market's patterns run counter to the cognitive and emotional patterns of the average person. Which may be why average people do not profit as short-term traders.

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.  His book, Enhancing Trader Performance, is due for publication this fall (Wiley).