-WORKING DRAFT-

Opening Range Bias: Evidence of Market Inefficiencies in

Intraday Returns?

ADAM GRIMES

Written in partial fulfillment of the requirements for the Masters of Business Administration degree
Fisher College of Business at The Ohio State University, Columbus, Ohio
1 May 2007

I. Introduction

The vast majority of academic research over the past several decades suggests that markets are
efficient, and that they quickly and accurately assimilate all new information. Three forms of the
Efficient Market Hypothesis (EMH) are common in current academic thinking: Weak form EMH
states that it is not possible to make trading profits based on information contained in past prices
and price patterns. Semistrong form EMH assets that all publicly available information is fully and
immediately reflected in the current market price. Strong form EMH asserts that no trading profits
can be made from any information, even secret insider information. The clear implication of all
these forms of EMH is that market prices are essentially random—new information introduces
random shocks to the system, and post-shock prices follow some form of a diffusion process,
perhaps with serial dependency in one or both of the first two moments.
Much of the theoretical foundation of modern Finance is based on this assumption that
prices more or less random and unpredictable. Many disciplines (such as Risk Management and
Portfolio Management), depend upon this assumption, as do most of the common-practice
derivatives pricing models. As Lucas (1973) first proved, random walk is neither a necessary nor
sufficient condition for market efficiency, but the presence of “quasi-predictable” elements in asset
prices could have far-reaching implications for much of the industry practice.
Much of the academic work that finds randomness in prices was done on weekly and
monthly returns. More recent work has confirmed has that the random walk condition appears to
hold reasonably well at weekly and monthly intervals, but is severely violated in high frequency
returns. In this paper, I examine a simple phenomenon—the relationship of the opening tick to the
day’s trading range is inconsistent with predications from random walk price models. This appears
to be a significant violation of random walk condition that occurs thousands of times each and every
trading day across a wide range of markets and market conditions.
 II. Random Walk Expectation

Consider this most simple question: What is the probability that a price randomly selected
during the trading day represents either extreme (the actual high or low) of the trading day? Is that
probability altered if the selected price is the first or last tick of the session? In other words, is the
high or low of the day more likely to occur at the open or close of the day than somewhere in
between? Intuition would suggest that any randomly sampled tick would have an equal probability
of lying anywhere in the day’s trading range. In other words, over many trading days, the opening
tick of the day, expressed as a percentage of the day’s range ( {Open – Low} / {High – Low} ) would
be ~ i.i.d. U(0,1). In this case, intuition is misleading.
Figure 1

50000 Random Walk Binomial Paths

2.5% Bin Width
5
43
Percent
2
1
0

0 .2 .4 .6 .8 1
Position of Open within Range

Figure 1 shows the results of a Monte-Carlo simulation of 50,000 random walk paths (P(up) =
P(down) = .50) through a 1,000 node binomial tree. The open, highest extreme, lowest extreme, and
closing prices were recorded for each iteration through the tree, and the open was expressed as a
percentage of the path’s range. Thus, a reading of 0% indicates that the opening tick was the lowest
price point in that particular path. The data as collected says nothing about the timing of the highs
and lows, or the number of times the extremes were visited, but only considers the position of the
open within the range. (The discrete binomial tree probably more accurately represents intraday
price movement than a continuous process would because of the granularity of the tick size in high
frequency returns.)
Though Figure 1 was generated by a random Monte Carlo process, it shows a marked
clustering of the opens at the highs and lows. This contradicts our earlier intuition which was that
the opening tick should be uniformly distributed through the day’s range. However, this clustering
effect is a well-known characteristic of Brownian random motion which is described by Levy’s
Arcsine Law. For the sake of notation assume:

• T the full length of the trading session

• t the current time in the trading session.
 • Thus, (T – t)/T describes the current time t as a percentage of the total session time.
• TH is the time at which the highest price of the day occurs and TL is the time at which the
lowest price of occurs.

Imagine a simple game of a fair coin flip, where the player is rewarded +1 for heads and -1 for tails.
This concept is applicable to daily asset pricing, but is most easily understood in context of
explaining the time between excursions from breakeven in a simple binary game of chance. A
running total of the score is kept for each coin flip. The question is, how likely is it that the player
will be breakeven (score of 0) at some specific point in the game. (Note that the cumulative record
of a game like this would exactly reproduce the simple binary tree experiment we used for a daily
price model.) The probability that the time spent above breakeven is at most x approaches the
following as the number of trials → ∞.

x
1 dt
π∫
(1)
o t (T − t )

The marginal density function is:

1 1
f (t ) = • (2)
π T −t t

which is a U-shaped function that approaches infinity as t → 0 and t → 1, suggesting that the high or
low point of the game is much more likely to occur at the beginning or end of the session than in the
middle. Again, this is a counterintuitive result—we might expect that the longer one plays a zero
expectancy game of chance the more likely one’s equity is to be breakeven, showing neither a win
nor a loss. The Arcsine Law says that it is more likely that the high or low equity point is more
likely to cluster at the beginning or ending of the game, and that repeated trials are actually more
likely to produce excursions above or below breakeven.
How does this apply to intraday market data? Simply put, if intraday prices can be explained
by a random walk process, the open should be near the high or low of the day more often than it
should be in the middle of the range. Based on the results of our Monte Carlo simulation, we could
expect that the open price would be within 5% of the high or low of the day about 15.2% of the
time.
 III. What Does the Data Say?

Table 1.
Position of Open Tick Expressed as Percentage of the Day's Range
(Open - Low) / (High - Low)
Instruments Opens within Opens within Number of Average Volume
5% of the Low 5% of the High Observations (thousands)
ALTR Altera Corp 7.4% 9.6% 2,517 8,312
AMD AMD Inc 9.4% 12.6% 2,517 8,969
C Citigroup 8.3% 9.9% 2,517 13,800
CC Cocoa Futures 21.3% 8.9% 2,494 5
CD Canadian Dollar Futures 6.4% 8.1% 2,517 15
CL Crude Oil Futures 8.5% 5.5% 2,507 78
CSCO Cisco 5.9% 9.2% 2,517 64,400
DJ Dow Jones Co. 7.2% 7.6% 2,330 13
DNDN Dendreon Corp 9.3% 15.1% 1,643 692
GC Gold Futures 8.6% 6.6% 2,512 31
GM General Motors 9.3% 15.1% 2,517 5,456
HAL Haliburton 9.1% 12.1% 2,517 8,443
HO Heating Oil Futures 10.8% 8.3% 2,510 18
INX S&P Cash Index 17.1% 15.7% 2,517 3,042
JY Japanes Yen Futures 7.2% 7.4% 2,516 28
KC Coffee Futures 18.2% 2.8% 2,494 8
LC Cattle Futures 15.8% 18.7% 487 13
LSI LSI Corp. 9.9% 11.2% 2,517 4,301
MSFT Microsoft 7.8% 6.4% 2,517 74,400
S Sprint Nextel 11.4% 11.9% 2,517 6,305
SP S&P Futures 7.5% 7.5% 2,524 74
T AT&T Inc 8.9% 12.0% 2,516 7,826
US 30 Year Tbond 7.2% 6.9% 2,502 156
W Wheat Futures 9.8% 9.3% 2,516 21
Mean of Observed Data 10.1% 9.9% 2,385 8,600
Random Walk Monte Carlo Mean 7.6% 7.6%

Table 1 gives open to daily range statistics for a several markets chosen at random. (In all cases,
after hours electronic sessions were excluded from the data.) The sample includes individual
equities from very deep liquid stocks (MSFT, CSCO) to fairly illiquid stocks (DNDN), futures
contracts across a range of liquidities and one calculated index. Comparing the observed data to the
Monte Carlo-derived benchmark (7.6% of opens within the top and bottom 5% of the daily range)
we can draw several general observations:

• In many cases, real market data is dramatically more skewed than the baseline.
• There does seem to be a relationship between this opening skew and volume. In general,
extremely liquid instruments exhibit clustering that very closely resembles the benchmark.
The most liquid instrument in Table 1 (S&P 500 futures) show an opening skew that is
indistinguishable from the benchmark.
 • Less liquid instruments exhibit a more dramatic skew. (We should note that the average
volume in table 1 does not account for the notional value of a futures contract and thus does
not truly reflect liquidity.)
• Some instruments exhibit an asymmetrical opening skew, while others are perfectly
symmetrical.
• Market microstructure issues (e.g. asynchronous trading) may explain the skew in the
calculated index.

IV. Other Returns-Generating Processes

Table 1 is a snapshot of an admittedly small cross section of markets. (Though the results
are not presented in this paper, I examined several hundred other instruments and found similar
results in the much larger sample.) Many of these markets show an opening skew that is much
larger than our random walk Monte Carlo results. However, it has been well established that high
frequency returns do not conform to random walk conditions. In particular, distributions for high
frequency (intraday) returns almost always show the classical leptokurtic deviations from
normality—marked peakedness, narrow shoulders and fat tails. These returns also frequently
exhibit some degree of autocorrelation at one or more lags, and usually have an element of
conditional heteroskedasticity. I specified two alternate returns generating models and re-ran the
Monte Carlo simulation to see if processes which matched the observed data more closely would
generate an opening skew which was closer to the market data.
Another 1000 node binomial tree was built using a continuous process with standard
normally distributed residuals. 25,000 iterations were run through this tree, each iteration
corresponding to a theoretical trading day, and the “days” were analyzed for opening skew. The
results were similar to the discrete Monte Carlo process: 7.9% of the opens were within 5% of the
low and 7.78% of the opens were within 5% of the high. (The asymmetry is probably due to
problems with Excel’s random number generator, and the fact that 25,000 iterations may not be
enough to assure convergence.) Equations 4 and 5 give the model for each node’s return and price
in this simulation.

rt = rt −1 + ε t , ε ~ i.i.d .N (0,1)
(4,5)
Pt = Pt −1 (1 + rt )

Equation 4 gives a return series which is normally distributed. However, observed intraday
prices usually show a high degree of kurtosis. A common modeling technique to generate “fat tails”
is to use a mixture of normals. The error term in equation 4 was modified to have a standard
deviation of 1 with probability .8 and a standard deviation of 3 with probability .2. The resulting
return series has a mean of -.001, skewness .021, and kurtosis 7.54. Figure 2 illustrates the narrow
shoulders and fat tails of this series.
Figure 2. Returns (Mixture of Normals) with Normal overlay

Returns (Mixture of Normals Process)

.4
.3
Density
.2.1
0

-10 -5 0 5 10
var1

Another 25,000 iterations were run through the tree using this mixture of normals process.
8.15% of the opens were within 5% of the low and 8.13% were within 5% of the high. Since
intraday market data has these fat tails, it is interesting to note that the open skew with this series
is significantly higher than with our baseline normal series. Intuitively, this makes sense because
large moves are more frequent with heavy tails, but are still relatively infrequent events. We would
expect this opening skew to be symmetrical since extreme events occur with equal probability to
the upside or the downside. If one of these large moves occurs early in the trading day, it is less
likely that a pure random walk process would move prices over the extreme of the day. Over many
trading days, this would tend to skew an unusual amount of the opens close to the high or low of the
day.
The notation AR(p) indicates an autoregressive model of order p. An autoregressive model
can also be understood as a linear regression with one of more lags of the dependent variable
included as explanatory variables. Observed intraday data for many markets shows some
autocorrelations at one or more lags. Equation 6 is a simple AR(1) model that was used to generate
another alternate model for the intraday binomial tree, using α = 0, β = .1 as inputs. (Note that |β| <
1 is required for stationarity. If β = 1 then the process has a unit root and can also be described as a
random walk. (Equation 5 is also an AR(1) process with a unit root.))

rt = α + β rt −1 + ε t , ε ~ i.i.d .N (0, σ 2 ) (6)

We would expect that this process could cluster more openings at the highs and lows of the
day, because, with β > 0, the next price is more likely to continue in the same direction as the
current change. In other words, if the return at time t is positive, the return at t+1 is more likely to
also be positive. If the first change of the trading day is positive, with a positive autoregressive
model for returns, it is more likely that price will continue to move away from that opening tick,
thereby generating an opening skew. In this case, 25,000 simulated iterations through the binomial
tree show 8.21% of the opens within 5% of the high and 8.10% within 5% of the low. Though not a
dramatic illustration, this open skew more closely matches the observed data than the simple
normal model. We would expect similar results from random walk with drift models, but have not
modeled that process in these simulations.
There is one more explanation that might be considered for one of the markets in Table 1.
The cash S&P index shows an extreme degree of opening skew. Remember, this is a calculated
(“cash”) index, not an actual traded market. It seems likely that the market microstructure
explanation of asynchronous trading could generate autocorrelation in this index, and that this
autocorrelation could be responsible for the opening skew. It is interesting to note that the S&P
500 futures, which tend to track the cash index quite closely throughout the trading day and share
virtually the same trading period as the cash index, do not exhibit any open skew beyond the
baseline.
In conclusion, pure random walks will tend to cluster opens at the high and low of the day
much more frequently than intuition would suggest. Actual market data shows degrees of opening
skew that are higher than those predicted by simple random walk models, but high frequency
returns show deviations from pure random walk conditions. Modeling returns with processes that
more closely match the observed data generates open skews which more closely match what we
observe in actual market data. It seems likely that many of the observed opening skews in real
market data can be explained as artifacts of various random price processes, and that most of these
observations are not evidence of inefficiency. Even so, some of the markets in Table 1 (and many
other markets not tabulated in that table) show degrees of opening skew which are quite extreme,
which cannot be explained through simple mathematical explanations. These skews tend to be
more extreme in futures than individual equities, and also tend to be more extreme in less liquid
markets. (This last is suspiciously suggestive of possible microstructure explanations.)