Making Money in Your Sleep: A Look at Overnight Returns

4 min read

How many times have you heard the phrase “don’t check the market daily?” It’s something your financial advisor or coach may have told you to help prevent emotionally-driven phone calls and trades. It turns out more than your emotions are at stake: stocks perform better when the market is closed.

Let’s take a look.

Summary

Equity markets perform better overnight. Holding SPY strictly overnight yields a 4% higher CAGR and experiences 44% less volatility relative to buy-and-hold price return.

Participating in equity markets strictly intraday would have cost you over 2x your starting capital and would leave you underwater even after 27 years of compounding.

Don’t look at your portfolio in the middle of the day. It’s the worst time to be in the market.

If you absolutely must look, look at the opening bell. Theres a 9% higher chance of seeing green first thing in the morning than later in the day.

Return Profiles

Consider the S&P500 price return from Jan 29 1993 to Jan 3 2020. In particular, let’s compare: overnight, intraday and continuous (buy/hold) returns.

Holding the S&P 500 purely intraday underperformed severely, so severely you would have lost your starting investment more than twice over! If you somehow managed to keep your account open you’d still be underwater some 27 years later. Ouch!

Win Rate and Magnitude

Let’s dig a little deeper to see if we can understand why there’s such a large performance discrepancy between overnight and intraday returns. Identifying daily win/lose rate and win/loss magnitude should help.

All approaches yielded a win rate slightly better than 50%. Where performance stands out is with regard to losses.

Holding only intraday experienced 9% more loss occurrences than holding overnight and the average loss was 64.3% larger. To contrast, intraday had 5% fewer wins than holding overnight and the average win was 57.5 larger.

In other words, overnight returns outperform not because they win bigger but because they lose less:

Distribution of Returns

More digging: let’s look at how the returns are distributed. There are 6781 trading days (occurrences) in this dataset. Assuming market returns are normally distributed (hint: they’re not), we would expect to see the following:

What we actually experience is closer to a Laplace distribution – higher peaks and fatter tails relative to a normal distribution:

The width or sharpness of the curve, called kurtosis, is correlated with volatility. The wider or rounder the curve, the greater the volatility.

We also see the curves are slightly off center, favoring positive returns. This makes sense since the win rate is slightly over 50%.

Discussion

So what does all this mean?

Day Trading

My first interpretation of the data is that successful equity day traders are either extremely lucky, found a market inefficiency to exploit or are full of sh*t. Statistically speaking, systematically day trading the broad market from open to close is unprofitable in the long run.

Difference in Returns

The difference between overnight and buy-and-hold CAGR is 30 basis points or a 3.84% underperformance for buy-and-hold. Not that much. There are many ETFs and mutual funds with expense ratios higher than that.

Where the real difference lies is with volatility. Buy and hold was 77.89% more volatile than holding positions overnight.

Leverage

Volatility also matters when applying leverage. If we are comfortable with the volatility of buy-and-hold SPY, we could leverage the overnight approach until we achieve the same level of risk.

Execution of a leveraged overnight strategy could be achieved by:

• purchasing SPY on margin at market close then selling at open
• purchasing SSO (SPY 2x) or UPRO (SPY 3x) ETFs and holding overnight
• trading /ES or MES futures contracts
• options on SPY, /ES or SPX, though you’ll have to deal with theta decay, vega (time value) movements, and other greeks.

Alternatively, one could attempt to hold short positions intraday or use SPUU (SPY -2x) or SPXU (SPY -3x) ETFs.

All leveraged tactics have costs and unique risks which detract from the value proposition of implementing an overnight position strategy.

Practical Application

Trading fees have essentially been eliminated across the board for equity trades. This leaves the costs to: bid/ask spread, low execution quality due to payment for order flow (PFOF), potential tax drag, and of course your time.

Since SPY is the most liquid ETF on the market, bid-ask spread will rarely be more than a penny wide, so this is largely a non-issue.

PFOF should also have minimal impact as the instrument being traded is again the most liquid ETF on the market. Virtually all market participants will have the same bid/ask spread at the same time.

If executing at scale in a [US] taxable account, tax drag will likely offset any total-return outperformance associated with an overnight strategy. Leverage would need to be implemented to overcome this drag, which will further eat into profits and increase the strategy volatility. I haven’t backtested a leveraged implementation of an overnight-only strategy but at a glance there is still much opportunity for total-return and risk-adjusted outperformance even after modest leveraging.

Finally, there is your time investment. This can be in the form of building automation to trade for you, personally attending the market at open and close every single trading day, or hiring someone to do it for you. Depending on how you value your time, this may or not be worth it.

Additional Resources

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