How to Play the Gaps

Dynamic Hedge blogs about correlation, relative value and quantitative analysis at http://www.dynamichedge.com

A gap in a chart happens when a stock opens lower or higher than the previous bar.  The “gap” traditionally refers to the visible space in the chart that this pattern creates.  You usually see them in daily or weekly charts because there is ample time between the close of one session and the opening of the next for news events to change sentiment and the supply demand relationship in the markets.  Naturally, in a headline driven market where many market moving events are unfolding, gaps are plentiful.

There are many different types of gaps: breakaway gaps, measuring gaps, exhaustion gaps, and common gaps.  I’m going to assume that all gaps are created equal in this post and use the most generic definition so as to remove subjectivity.  In my analysis in this post, I treat every opening print a more than 0.3% away from the previous closing print as a gap.  I don’t care if a gap creates a visible gap pattern in the chart because on the opening of the market PnL losses are real and affect traders regardless of what the chart looks like.

Why are gaps important?  Gaps represent the most pure form of market punishment to wrong-way traders and the most pure reward for right-way traders.  This is not your run of the mill position slowly trending against you or in your favor — this is a violent rejection or reward of your trading thesis.  The acute nature of the pain and pleasure and the trader reactions associated with the emotions of loss and reward leave an unadulterated behavioral footprint on the market.

So how should one trade these gaps?  Well, it depends.  We keep a track of the changing patterns in the market through our pattern recognition algorithm.  Those who have been following its progress in Chartly know that it’s a truly remarkable tool.  Below, we’ve analyzed the gaps in the S&P 500 Futures ($ES_F) for the previous three months and presented the highest probability intraday patterns the market generates when each gap scenario occurs.  It’s important to note that market conditions change constantly over time.  The past three months are not the same as the prior three months.  Patterns change continually.  The examples below display a significant follow thru in the direction of the gap, but there are times when the market behaves completely different and favors a bounce.  We’ve started to keep track of these on a rolling basis for this exact reason.

Remember, these are not suppositions about how traders react or anecdotal observations.  This is real data crunched using the most robust pattern recognition software available to anyone.

Gap Up Scenario 1: 0.3% – 1%

These are medium-sized gaps and you tend to see some reflex selling and profit taking off the open.  Shorts are encouraged early in the session but eventually the emboldened buyers step back in and you see new highs in the afternoon.  Notice that they tend to close near unchanged from the opening print (obviously higher than the previous day).

Gap Up Scenario 2: Greater Than 1%

These are a sampling of the larger gaps we’ve been seeing lately.  They tend to have very shallow pullback off the opening print and see new highs early in the morning.  These gaps tend to close at or near the high of the day.

Gap Down Scenario 1: 0.3% – 1%

These are medium-sized gap downs.  They are characterized by very choppy action in the morning.  They trap more longs who buy on the new highs in the morning looking for a bounce (classic).  They press the low of the day late in the afternoon trapping longs and hitting sell stops along the way.

Gap Down Scenario 2: Greater Than 1%

These large gap down scenarios see almost no relief for longs off the open.  In fact, these scenarios will often attract sellers off the open.  Typically, this is a situation where the longs are trapped and the market hits sell stops all day long.  Hope is abundant but the bounce usually doesn’t come.

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