Overnight Edges: The Money is made when you sleep

As a beginning to one of our Quantitative Research Articles, we thought of discussing an intriguing piece of research on overnight edges and its importance.  As a trader, we look to exploit inefficiencies in the market. Before devising a strategy some of the questions we need to ask ourselves are: At what point during the month or week or day is most of the money made? Is there an edge in holding positions overnight or do most rallies happen during the day?

Since most industry analysts and fund managers benchmark the index for relative performance, we tend to do most of our basic research taking the benchmark. The goal of most investors is to beat the benchmark. Though the industry sees the performance in terms of the Rate of Return or CAGR, we prefer to see the Compounded Annual Return/ Max Drawdown (CAR/MDD) as a more suitable metric to judge performance.  So what did the benchmark do in the past?

We have taken 4000+ trading days and 12 years of Data to run the analysis. This is the BUY and HOLD return for the Index for the past 12 years.

Even though the Index has done decently well in terms of the Annual Return, the drawdown of -59% would throw even the best of investors off the hook. Most of us do not have the emotional stability to stay invested after losing more than half our capital. At a (20%) drawdown most of those who claim to be long term investors tend to fold their cards and pack up. The fact that most of us do not have the emotional stability that Buffett has, urges us to uncover better ways to invest. Better ways to reduce the drawdown numbers without losing the profits.

Hence, we thought, what if we held positions only overnight. We buy at the close every evening and sell at the open. We aren’t exposed to the noise throughout the day. These results will surprise you.

Returns go up to 15% p.a. and drawdown goes down to -9%.  The CAR/MDD is phenomenal.  The main take back from this is that most of the money is made overnight and not during market hours. In fact, holding positions during the day only adds to your losses, reduces your returns and increases drawdown. Even though this system cannot be traded, since the trading edge is too thin and the transaction cost will eat into your profits, it can surely be used as a building block.

This is primarily what BTST (buy today, sell tomorrow) trading strategies work upon. Below, I have added the yearly results of holding the index overnight and selling it at the open, and the second table shows the relative buy and hold returns for the same duration.

The results speak for themselves. Holding the index overnight definitely has an advantage. The overnight edge has never seen a down year and the maximum drawdown it has seen is -9.2%. In fact, recent years have seen an improvement in the trading edge and CAR, clearly showing that the strategy has not lost its essence. The only shortcoming would be during extreme bull years like 2009 where it severely underperforms the index. But it’s easier to make less than to lose more. Buying the index overnight and selling at the open is not a strategy one can deploy since the transaction cost will eat into your profits. It can surely be used as the foundation to build a sounder strategy using the same principals.