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.