Trading Model Construction: Tracking the S&P 500

As a follow-up to "How to Build Your Own Trading Model in 8 Steps," I will now walk you through an actual example of the construction of a trading model.

Step 1. Develop a Hypothesis

I want to test whether we can observe and quantify momentum-based movements in the market. Thus, if the markets are moving up, will they continue to move up? Conversely, if the markets are moving down, will they continue to move down?

Momentum can indicate buying or selling by large institutions that are investors that can essentially move markets.

If the answers to my questions are yes and yes, can we profit from such moves?

Step 2. Build a Database

When building a database, the most important question to ask yourself is what data do I need to accumulate?

The "market" is a very general term, which also can also be quite subjective when attempting to define it. Given that the S&P 500 is the broadest basket of large capitalization stocks; is the most widely used index as an investment benchmark ; and, has the most active and liquid exchange-traded funds (ETFs) associated with that index, I believe that the SPX is most representative of the overall stock market.

Over many years, I have developed and maintained a database of the SPX. My data goes back to 1950 and lists by date, the S&P 500's opening price, high price, low price and closing price. I have spent many hours on data services such as Bloomberg, Reuters, Yahoo Finance and other databases accumulating this information and insuring that the data was "clean" and researched any "issues" when they may have occurred.

Many of the database issues took place in earlier years. For example, prior to 1962, only closing data is available and I have had to live with such limitations in my model-building endeavors. However, for the purposes of this model, only closing data is necessary, so we're not constrained by the lack of detail before 1962.