Betting On The Gaps Themselves

Many people are fixated on the idea of long term "investment" while others would like to explore for better return day trading. Here is an interesting chart with net gains from several trading strategies. You may be surprised by the results.

The results above is summarized in the following table for your convenience.

Several interesting observations from the chart.

First, the results of the strategies:

• The clear winner here is going long when S&P is above its 365 days simple moving average. (I cheated on this one by optimizing the moving average with full benefit of hindsight)
• The clear loser here is the day trading strategy that buys the open everyday and exit on 4 pm close
• The gap strategies perform somewhere in between
• The best performing gap strategy among the 3 basic ones is the one that go long only after 2 consecutive down days. Yes the net gain was lowest among the three strategies but it has the lowest exposure duration in the market while keeping majority of the gain. If commission and slippage is taken into account, it is definitely the winner.

So, I am sorry to say, day traders who bet blindly in regular trading hours really do not stand a chance. Not in the bullish period, and definitely not in the bearish period.

Second, the overall gap to regular session relationship has been changing:

• During the 1990s, gaps account for majority of the gain. Daytraders laughed at long term investors saying that they have a bull market as the daytraders were profiting from the short side most of the time
• During 2000-2003 the Internet bubble burst period, gap play suffers but definitely better than the day time bulls
• During 2003 to 2008, the gaps are the gain. Daytraders continue to laugh at the long term players as they can essentially short into every day session to pocket some profit.
• During 2009 to now, the gaps and the regular sessions are contributing about the same amount so far on the total gain. It is a very drastic change for the day session daytraders as it is first time in history that the day session is giving the bulls equal ground.

This transformation of the relationship affected how the index future market functions during each of these periods. I am not sure if this change in behaviour is a function of the 24 hours nature of the market nowadays or if it is something else structural.

Third, trading the gap itself is a valid strategy. I am not talking about trading the gap fill here. I am talking about speculating on the gaps themselves. In another words, making bets on the direction and magnitude of the gaps in overnight is a valid strategy.

Personally I know a few small hedge funds doing this. It is a profitable strategy with several restrictions like limited size capacity and potential slippage issues. It is a very sexy idea because it is trading strategy at its finest – you simply execute your trade and have your position monitored automatically. Next morning, no matter what, it is done and you get to do other things.

Notes

I have been asked many times to write about gap trading techniques as I do gap fill plays so often during trading hours. But you cannot trade the gap fill plays until you understand the gaps themselves. Hence this first introduction showing you that the gaps are heavily bullish biased and that they were the main bullish driver of the market until 2009.

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