Day Trading: Momentum Strategy

A study called Market Intraday Momentum by Lei Gao, Yufeng Han, Sophia Li, and Guofo Zhou reveals a significant and consistent pattern in market behavior: intraday momentum.

This phenomenon shows that the market’s performance in the first half-hour of trading can predict its behavior in the last half-hour of the same day.

What is Intraday Momentum?

Intraday momentum, as documented in the research, describes a specific return pattern within a single trading day. It posits that the return observed in the first 30 minutes of market opening, calculated from the previous day’s close to 10:00 AM Eastern Time, has a statistically and economically significant positive correlation with the return in the final 30 minutes of trading, from 3:30 PM to 4:00 PM Eastern Time.

This is a unique contribution to the existing literature on market momentum, which has largely focused on monthly or weekly return patterns across different assets. The study utilized high-frequency data from the S&P 500 ETF (SPY) spanning from 1993 to 2013 to identify this pattern. Thus, the results is a bit old, but you might find it interesting to conduct your own research.

Why the First and Last Half-Hours Matter in Trading

The special significance of these two periods within a trading day is not arbitrary. Market dynamics often create a “U-shaped” pattern in trading volume and volatility throughout the day.

• The First Half-Hour: Most major economic news and earnings reports are released before the market opens. The initial 30 minutes of trading are characterized by high volume and volatility as market participants process and react to this new information. The market often opens at a new level, reflecting these developments.

• The Last Half-Hour: This period also exhibits high volume and volatility, signaling its importance. Institutional traders, in particular, place great emphasis on closing stock prices for various reasons, including calculating portfolio returns, portfolio rebalancing, tallying mutual fund net asset values, and marking financial contracts to market. Additionally, market makers aim to unload inventory to avoid overnight risk.

The study empirically documents a positive correlation between returns in these two crucial half-hour windows.

Profiting from Intraday Market Patterns

The predictability of intraday momentum is not just a statistical curiosity; it offers considerable economic value for market participants.

• Market Timing Strategies: A simple market timing strategy that goes long if the first half-hour return is positive and short if it’s negative yields an average annualized return of 6.67%. This is notably superior to a daily Buy-and-Hold strategy, which offers 6.04% but with a much higher standard deviation (6.19% versus 20.57%), resulting in a significantly better Sharpe ratio of 1.08 compared to 0.29 for Buy-and-Hold. The outperformance remains significant even after accounting for transaction costs.

• Utility Gains for Investors: For a mean-variance investor with a risk aversion of 5, the predictability based on the first half-hour return can generate extra risk-adjusted returns, or “certainty equivalent gains,” of 6.02% per annum. When incorporating the twelfth half-hour return (the half-hour before the last), these gains can increase to 6.18% per annum. These figures highlight substantial economic benefits for investors who utilize this intraday momentum compared to those who do not.

When Intraday Momentum is Stronger

The study identified several market conditions that amplify the strength of intraday momentum:

• High Volatility Days: The predictability generally rises with volatility. On days with high first-half-hour volatility, the R-squared (a measure of predictability) increases significantly, suggesting that greater uncertainty leads to stronger trend persistence.

• Higher Trading Volume Days: Similar to volatility, higher first-half-hour trading volume also correlates with stronger predictability.

• Recession Days: Intraday momentum is found to be significantly stronger during recession periods compared to expansions. This aligns with the observation that volatility is typically higher and liquidity often lower during recessions, making momentum effects more pronounced.

• Major Macroeconomic News Release Days: Days when important economic news, such as the Michigan Consumer Sentiment Index (MCSI), GDP estimates, Consumer Price Index (CPI), or Federal Open Market Committee (FOMC) minutes, are released show a considerably stronger intraday momentum. For instance, on FOMC release days, the R-squared was astonishingly high at 11.0%, and market timing strategies yielded an annualized average return of 20.04%.

Understanding the Underlying Explanations

The research paper proposes two primary economic explanations for this intraday momentum pattern, rooted in investor behavior and market structure.

• Infrequent Rebalancing: Some institutional investors, due to factors like slow-moving capital or institutional constraints, may not rebalance their portfolios immediately at market open. Instead, they might delay their trading decisions to the first or last half-hour of the day. If different groups of investors rebalance in these distinct periods and trade in the same direction, it can generate a positive correlation between the first and last half-hour returns.

• Late-Informed Trading: This explanation suggests the presence of investors who become informed about early morning news later in the day or process information more slowly. For these “late-informed” investors, the last half-hour is an attractive time to trade because of its high liquidity and the desire to avoid overnight risk. If they act on early information by trading in the same direction as those who reacted quickly in the first half-hour, it generates the observed positive correlation. Mutual fund investors, who trade at closing prices, can also be considered “late-informed” in this context as they retain the option to wait before instructing their fund managers.

Broad Applicability: Beyond the S&P 500

The intraday momentum is not limited to the S&P 500 ETF (SPY). The study confirms its presence and significance across ten other actively traded domestic and international ETFs. These include diverse asset classes such as the Dow, NASDAQ, and Russell 2000 indices, as well as financial, real estate, bond, and various international equity indices.

• The predictability in these other ETFs is often even greater than in SPY, potentially due to their lower liquidity leading to larger price impacts from last half-hour trading.

• The persistence of this pattern across a wide range of ETFs further supports the underlying behavioral explanations of infrequent rebalancing and late-informed trading.

Furthermore, the profitability of exploiting this momentum survives the impact of transaction costs, particularly in the post-decimalization era (after July 2001) when spreads narrowed significantly due to technological advancements and increased competition.

Conclusion

The evidence for market intraday momentum is robust, offering both strong statistical and economic significance. This pattern, where early morning returns predict late afternoon returns, is a pervasive feature of the market, observable across various conditions and asset classes.

While calling for further theoretical development, these findings underscore the intricate dynamics of intraday trading and offer insights for those seeking to understand and potentially capitalize on short-term market movements.