Use This Formula to Trade Gaps

The market action the last few days hasn’t done anything to change my market bias. I’m still looking to play both sides. More opportunities are revealing themselves on the long side than the short. I suggest taking the trades as they trigger and playing things close to the vest until there is a more significant edge in one direction or the other.

In addition to the discretionary techniques I so often discuss in the column and utilize in my own trading, I also design and use mechanical strategies. Some of the most common types of strategies that system traders use are those involving gaps. For instance, if the market gaps down big in the morning, they may look to enter it and profit from the bounce, expecting that the gap was an overreaction.

One issue many traders have is defining how big a gap should be in order to qualify for a trade. Some traders will use a dollar amount. Others will use a percentage amount. If you truly want to back test your strategy, I would suggest that neither of these methods are appropriate. What needs to be looked at is the size of the gap in relation to a “typical” recent gap in order to gauge the significance. To determine what a “typical” gap is, I use the following formula:

“Typical Gap” = Average of the Absolute Value of the last X gaps. (Where X is the number of days you want to use in the calculation.)

If today’s gap is some multiple larger than the typical gap, it is “big”.

To see the significance of this and why using a dynamic definition of a “big” gap is more appropriate, take a look at the QQQQ chart below. The red indicator line at the bottom shows the percentage size of the average gap over the previous 50 days.



What is apparent when looking at this is that the size of a typical gap has shrink significantly over the last 5 years. A gap of 1% up or down was pretty typical in 2001 and 2002. A gap of 1% in 2004 or 2005 would be huge. A typical gap these days is 0.25%. Overnight risk and overnight opportunity has steadily contracted over the last 5 years.

If you try to devise a strategy that trades gaps of 1% or more, when back-testing over the last 5 years, you will find that each year you would have less and less trades. Instead, for more consistent results, you should look to base the gap size off of a “typical” gap as described above.

Best of luck with your trading,

Rob Hanna
RobHanna@comcast.net

For those who may be looking to expand their knowledge beyond just market timing, my Hanna ETF Money Flow System utilizes the VIX in generating trading signals for spread trades.

Rob Hanna is the principal of a money management firm located in Massachusetts. He has spent the last several years developing and refining methods for trading in stocks across multiple time frames. He selects stocks using both fundamental and technical criteria, and then trades them using technical analysis techniques.