Chapter 10. Putting It All Together
Discussions of gaps are frequent in the technical analysis literature. Pick up an issue of Technical Analysis of Stocks and Commodities or Active Trader and often there is an article that mentions gaps. Turn on the financial news, and you will probably not have to listen long before you hear gaps mentioned. Pick up a book on technical analysis, and you can find a discussion of gaps. Do an Internet search about technical analysis, and you can find a proliferation of Web sites that discuss gaps. Although this interest in gaps is not new, there has been surprisingly little systematic study of gaps.
Technical analysis has traditionally been a visual activity. Although computer technology has allowed for algorithmically generated trading based on the techniques of technical analysis without a human looking at a chart, the technology has also allowed for more colorful and visually rich charting to reach the eyes of more and more traders. No longer does a trader need to construct charts by hand, nor does a trader have to wait for yesterday’s data to begin constructing charts. Data and charts are available instantaneously. Although this has allowed for the quick recognition of more and more complicated patterns by a greater number of traders, the interest in basic tools such as gap analysis remains.
When we started systematically analyzing gaps, a few traders said that gaps were becoming an outdated tool. Their analysis was that gaps were becoming less and less frequent. Just as the move to decimalization caused the statistics for the number of stocks that were unchanged for a day to decrease, they reasoned that gaps would become less frequent. With price changes tracked at smaller increments, they reasoned, gaps would be less likely. They also cited increased market activity as a reason to postulate that gaps were becoming less frequent in the market. Thinly traded stocks tend to gap at a high rate because of discrete market activity. Thus, they reasoned, as more and more traders have instantaneous access to news and market information and trading volume increases, gaps will become less frequent. Thus, they would conclude, gaps are an interesting historical phenomenon in the markets, but they are becoming less and less useful to traders.
Surprisingly, we have found that this is not the case. In fact, we have found an increasing number of gaps in the past few years. And these gaps are not limited to small, lower volume companies. A number of gaps exist for high market cap stocks, such as AAPL, WMT, and MCD. In 2011, we found more than 32,000 instances of gaps; this was more than twice the number of gaps 5 years earlier and more than three times the number of gaps a decade earlier. Thus, a trader will not find a lack of gaps.
Two frequently heard phrases when analysts talk about gaps are “A gap is always filled” and “Trade in the direction of the gap.” Interestingly, these two bits of advice are somewhat at odds with each other. Suppose a stock gaps up. A filling of the gap would mean a price reversal occurs as price falls to close the gap. If this occurs, a short position would be profitable. If, instead, the price movement is going to continue in the direction of the gap, price will rise and a long position would be profitable.
One way this conflicting advice could be resolved is that a gap is quickly filled, somewhat in a price rebound, and then price continues in the direction of the gap. To see if this happens, this book considers price movement in the short term, 1, 3, and 5 days after a gap and then a bit longer, 10 and 30 days after a gap. The general results, presented in Chapter 2, “Windows on Candlestick Charts,” point to an immediate price reversal for up gaps. On average, when a stock gaps up, the price movement over the next 10 days tends to be in a negative direction. These results are consistent with what you can find in Chapter 9, “Closing the Gap,” when the average up gap is closed within 5 days. However, by 30 days, the upward movement in the direction of the gap has, on average, returned.
What about down gaps? Chapter 2 discusses that the negative price movement tends to continue the day after a down gap. However, by Day 3 the price trends upward. Stocks that experience down gaps have, on average, positive 3-, 5-, 10-, and 30-day returns. These results are consistent with what you learned in Chapter 9 about the filling of down gaps. The average down gap is filled within 6 trading days.
Of course, looking at averages over a large sample size can mask some underlying tendencies of some particular groups of stocks. Chapters 5, 6, and 7 examine the impact of other variables.
Chapter 5, “Gaps and Previous Price Movement,” examines the impact of price movement on Day 0 (day of the gap) and Day –1. In candlestick terms, you studied the importance of white versus black candles on those 2 days.
You might think that spotting a black candle followed by another black candle that gaps down would be an ominous sign that downward price movement is gaining momentum. However, the results show that when a black candle on Day –1 is followed by a gap on Day 0, price movement tends to reverse to an upward direction on Day 1, and this upward movement continues for at least 30 days. This suggests that the downward gap was an overreaction and the price fell too far. Likewise, you might think that an up gap, especially when it occurs in a White-Up-White pattern, suggests strong upward price momentum. Again, the results bring this traditional reasoning into question. Stocks tend to reverse direction and have negative returns for a couple of weeks following an up gap.
Chapter 6, “Gaps and Volume,” considers a classic variable used by technical analysts to confirm price movements: volume. Traditional analysis suggests that price movements, especially upward movements, on high volume are more meaningful than when they occur on low volume. However, the analysis of volume, as it relates to gaps, does not provide a great deal of useful information or added value. You saw in earlier chapters that gap downs tend to be followed by continued price decline on Day 1, but the price quickly shows reversal. The biggest insight that volume gives you is that price reversal tends to occur sooner for down gaps that occur on moderately low volume compared to those occurring on high volume. For example, low-volume down gaps tend to reverse on Day 1, whereas high volume down gaps tend not to reverse until after Day 3.
Chapter 7, “Relative Price of Gap Occurrence,” focuses on the impact the price at which a gap occurs relative to the average price for the stock has on the profitability of trading strategies. Most up gaps occur at above average prices and most down gaps occur at below average prices. The vast majority of gaps occur within a 75% to 125% range of the stock’s price moving average. Some gaps, however, do occur at extremely high or extremely low price levels. A consistent result is that stocks that gap down at above average prices tend to reverse price direction immediately. This suggests that purchasing a stock that gaps down on Day 0 at an above average price at the opening the following day, Day 1, can, on average, be a profitable trading strategy.
Stocks that gap up tend to have negative returns immediately following the gap. These negative returns tend to occur for a longer period of time for the stocks that gap up at relatively low prices. Stocks that gap up at a price below their 10-day, 30-day, or 90-day moving average still have negative returns at the 10-day holding period. By the 30-day mark, these returns have become positive.
The first part of Chapter 8, “Gaps and the Market,” studied the 25 days (from 1995–2011) with the highest number (553 or more) of gaps. All 25 have occurred since 2007 and 14 were in 2011. Investors know that 2011 was extremely volatile. The high gap activity was another way in which market volatility was manifested. Also discussed are the underlying causes behind these high gap days. Many were heavily influenced by events outside the United States.
From an investing perspective, you looked at high gap days to see if they gave any clue about future market direction. For example, if a high number of stocks gapped up on a particular day, is that a signal that the market is headed up or headed down? It did not appear that high gap days dominated by gaps in a particular direction give reliable market timing signals.
Two other ideas were considered for making use of the high gap day list. One idea is to look to the dominant group for guidance. For example, if many stocks gapped and 99% of them gapped up, do those stocks that gapped up represent some type of trading opportunity? For days with a high number of down gaps, the best idea seems to be to go short on the down-gapping stocks on the day after the gap, looking for a downward continuation. But, after Day 1 it appears that it would be better to be long, hoping for a reversal. After Day 1 it appears that being long is a solid idea. The magnitude of the returns is quite high, which is certainly intriguing. The data suggest a similar approach to trading gap up stocks on a day with many up gaps. For Day 1 prices are likely to continue moving up; a continuation approach looks best. After Day 1 a reversal strategy looks better, but the evidence here was not as strong as it was for the down gaps.
A second way to use the high gap day list would be to focus on the small number of stocks moving opposite to the herd. The returns here seem to offer some nice potential. But given the small sample size, you dug into the details to see what was causing this group to move in an opposite direction from the majority. What you saw is that some dramatic company-specific event was the cause. Although there appears to be some potential in focusing on this group of stocks, each case needs to be considered separately.
You also examined whether prior market movements should influence your gap-based trades. For example, assume that the market has been in a strong uptrend and you are considering whether to go long or short with stocks that have gapped up. Do you go long, staying with the stock’s upward movement and the market’s upward movement, or do you perhaps look for a reversal? For up gaps, prior market movements had little impact. For down gaps it does have some impact. Generally you want to go long on a down gap expecting a reversal regardless of the prior market direction. But, if the market has been strongly down over just the last 1, 3, 5, or 10 days, then the downward move of the stock may continue for the next 1 to 5 days.
It would be nice to say that we found the Holy Grail vis-à-vis gap trading, but we have not. However, we think that this book provided some useful information to help guide gap-based trading. We thought that the consideration of some variables, such as volume, might greatly improve results, but were disappointed to find the variable studied didn’t have more impact on returns. However, that a particular variable doesn’t provide much help is, in itself, useful. Consider an analogy. Suppose you are about to start searching for diamonds in a square 4-acre field. If someone says, “I’ve looked hard in the northwest, northeast, and southeast quadrants and haven’t found anything,” is that valuable information? It is, assuming you trust the person who is making the statement.
For now, gaps seem to be here to stay. If the recent trend continues, you may see even more gaps. In the search for higher returns, this book provided some good clues of where to focus your efforts and some guidance concerning things that are probably a waste of time. The authors began this book planning to produce an in-depth study that would say most everything that could be said about gaps. However, gaps have proved to be even more interesting than imagined. Stay tuned. The study of gaps will probably continue. At least, after we take a short break.