Why is it Challenging for Traders to Profit in the S&P 500?
The S&P 500 has been in a historic bull market for several years, characterized by a relentless upward trajectory with only minor dips along the way. At first glance, this persistent trend seems like a golden opportunity for traders to make substantial profits. However, paradoxically, the S&P 500 has proven to be a challenging market for traders seeking consistent gains. Understanding why this is the case requires a deeper dive into the nature of trading, market dynamics, and the specific characteristics of the S&P 500.
The Nature of Trading vs. Investing
To comprehend why the S&P 500 poses such challenges, it’s essential to distinguish between trading and investing. Investors typically adopt a buy-and-hold strategy, purchasing assets with the expectation that they will appreciate over time. Traders, on the other hand, aim to capitalize on short-term price movements. They buy with the intent to sell quickly, often completing multiple trades or “round-turns” within a single day. This approach presents a fundamental problem: the S&P 500’s trend primarily benefits those holding overnight positions, not day traders who operate within the confines of the trading day.
The Overnight Effect: A Surprising Revelation
A study conducted by Bespoke Investment Group highlights a surprising and counterintuitive finding: since 1993, nearly all of the S&P 500’s gains have occurred outside of regular trading hours. Specifically, the study found that purchasing the S&P 500 ETF (SPY) at the market open and selling at the close each day resulted in a cumulative return of -13.9% over 27 years. In stark contrast, buying SPY at the close of the trading session and selling it at the next session’s open yielded a remarkable return of +634.2%. This phenomenon, known as the “overnight effect,” has significant implications for stock market investors.
Implications for Investors: Understanding the Overnight Effect
The overnight effect suggests that the value of a portfolio can change substantially overnight, independent of the day’s trading activities. Many private investors might suspect a conspiracy preventing them from capitalizing on these overnight moves. However, the reality is more straightforward and involves the mechanics of the futures market. When the US stock market closes at 4 p.m. EST and reopens at 9:30 a.m. the next day, stock prices continue to fluctuate. This is because the S&P 500 futures market, along with futures for other major indices, remains active for most of the 24-hour period.
The Role of Futures Markets in Price Setting
The US stock futures market only closes on Friday nights and reopens on Sunday at 6 p.m. EST, functioning as a five-day continuous market. During nighttime hours, when only futures are open, the S&P 500’s price is influenced by futures market participants. These markets often experience thin trading volumes until close to the market open, with prices driven by supply and demand, news, and other factors impacting the market. The impact of these overnight trading activities is profound, as they often set the stage for the market’s opening prices.
The Impact of Overnight Trading on the S&P 500
Over the past 27 years, the noise generated during the 6.5 hours of daily market activity has contributed little to the S&P 500’s overall gains, which have largely occurred overnight. The chart illustrating the Overnight Effect clearly demonstrates this: the red line shows the accumulation from the day’s close to the next day’s open, while the green line represents normal trading hours (NTH) accumulation from open to close. Notably, NTH did not significantly contribute to SPY’s total return until around March 2021. Since the ETF’s inception, overnight positions have contributed 405.4 points compared to just 36.4 points from normal trading hours.
The Undervalued Power of Technical Analysis
This phenomenon underscores the undervalued power of technical analysis in modern investing. Futures traders have long relied on technical analysis and charting to navigate markets, well before these tools became popular among a broader audience. Understanding technical analysis and the mindset of futures traders can be invaluable, even for those who are not traders themselves. Technical analysis provides insights into market trends, price patterns, and potential future movements, offering a strategic advantage in anticipating market behavior.
The Psychological and Strategic Challenges for Traders
The S&P 500’s unique market dynamics present psychological and strategic challenges for traders. The discrepancy between overnight and intraday gains can be frustrating for day traders who rely on short-term price movements. This environment requires traders to adapt their strategies, possibly incorporating overnight positions or adjusting their trading hours to align with market conditions. Additionally, the reliance on technical analysis and understanding market sentiment becomes crucial in navigating the complexities of the S&P 500.
Adapting Strategies for Success in the S&P 500
To succeed in trading the S&P 500, traders must adapt their strategies to account for the overnight effect and the market’s unique characteristics. This might involve incorporating longer holding periods, utilizing futures contracts, or employing options strategies to hedge against potential losses. Traders should also consider diversifying their portfolios to include other asset classes that may offer different risk-reward profiles. By understanding the nuances of the S&P 500 and leveraging technical analysis, traders can enhance their ability to navigate this challenging market.
