Gaps and the Open

June 23, 2014 Adam Grimes, CIO, Waverly Advisors

Outline: – Definitions: What is an opening gap? What is gap closure?

– Why do markets gap on the open? – How might the world be changing? – Are there any statistics associated with opening gaps? – How might we use what we know? Finding trading opportunities Risk management

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What is a Gap? Two possible definitions:

– Open is <> the previous session’s close This will result in many gaps, but a large number could

be due to noise. – Open is <> (outside) the previous session’s range. Open is above the high or below the low Fewer gaps, but small gaps may still be questionable

Complications: – Include pre- and post-market data? – What about markets whose primary trading hours are

outside US hours?

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Gaps: C ≠ O[1]

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Gap Outside Previous Range

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C ≠ O[1] w/ 5 pt. Filter

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Gap Closure Two possible definitions:

– Amount of gap that is reversed during the trading day – Binary: gap is either open or closed at the end of the day

Example: If using open outside previous day’s range: – For gap up, closure is the amount the low of the current

day trades toward the previous day’s high. – If the current day ends with the low above yesterday’s high

the gap is said to be open at the end of the day.

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Why Do Markets Gap? First, do not assume that everything in the market has

meaning. Purely random walk markets would gap on the open, just due to random chance.

Some gaps are obviously news-driven. – Earnings for stocks. – Crop reports for commodities. – Central bank announcements for currencies. – Macro events for all markets.

Most agencies try to time reports so that they have minimal market impact, i.e., during active, liquid trading hours. – The markets’ job is price discovery. If they are closed, market

participants cannot price risk or impact of news, and emotional reactions are possible.

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Some Gaps Are Different What about markets that do the bulk of their trading

outside of domestic market hours? – ETFs for currencies – Foreign stock indexes – ADRs, etc. – Some commodities have liquid foreign sessions.

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Not “Actual” Gaps

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Nor Are These

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But What About These?

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Gap Drivers: Summary Traditionally, gaps are the markets’ attempt to deal

with a major shift: new information, new conditions, new psychology.

Large gaps often represent a significant shift in fundamentals.

Larger gaps may be more significant. – Volume may also be significant, but quantitative tests do

not find an edge.

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The World Is Changing Even a few years ago, many markets had short liquid

sessions and large overnight gaps were a significant risk. Many markets had pit sessions that dominated trading. Many pit sessions had complicated opening procedures

that worked to balance the flood of opening orders. Under these conditions, the opening print might have

been more significant than it is today. Today, more markets are tending toward twenty four

hour trading. (Weekends are still largely closed.)

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The World is Changing Non-regular trading sessions can be illiquid.

– Sometimes, extremely wide spreads. – Large orders can cause large price spikes. – Execution skills matter in this environment. Avoid market orders, if possible. Be careful with stops that can be triggered on spikes.

Currencies are essentially open 24 hours, but many are very illiquid during most of that time.

Don’t assume that all prices you see in all markets would have been tradable.

Think about what the trend will be in the future. – Most likely, continued trends toward more continuous trading.

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Gap Closure Statistics Opening gaps tend to reverse. Very small opening gaps will close simply due to

noise. – A tendency driven by noise (i.e., no different from random

walk) is not an investible tendency. Moderate opening gaps tend to close with

statistically significant probability. Consider, also, the tendency for partial closure. Very large opening gaps tend to not close.

– Assumption might be these represent more significant shift in underlying fundamentals.

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A Quick Gap Study Three years (9/26/2009 – 9/24/2010) of data on 39

stocks. 29,208 trading days. Define gap as simply outside previous day’s range. Market gaps 7,688 days = 26.3% of all days. Average gap is very small.

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Gap Statistics (in basis points)

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Gap Statistics

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Gap Closure Stats These gaps close 75.8% of the time, but many of

these gaps are very small. – Some may simply represent bid/ask bounce. – May not be “economically significant”, meaning that, even

if they exist in the data, they may be too small to overcome transaction costs.

In general, moderately-sized gaps (< 5%) tend to close around 70% of the time.

Larger gaps (> 5%) tend to close less than 30% of the time.

There are also time of day tendencies to consider.

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Position of Open in the Day’s Range

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Location of the Open The Open tick is more likely to be at one extreme of

the day’s range than in the middle. – (This is also consistent with the behavior of random walks

(the arcsine law of random walks, see, for instance Acar and Toffel, “Highs and Lows: Times of the Day in the Currency CME Market.” (1999)))

There might, however, be implications for risk management.

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Relative Volatility by Time of Day

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Trend Strength by Time of Day

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Application: Risk Management If you have a problem with a position on the open, with a

moderately sized gap, consider the tendency for gap closure. – E.g., holding a short against a moderate gap open: the statistical

tendency is for that gap to at least partially reverse.

If you have a problem with a position off the open, action may be required. – “Off the open” means price movement away from the opening

price against your position.

If you have a problem with a very large opening gap, action may be required.

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Have a Plan A good trading plan encompasses every possibility. Realistically, it is not possible to account for every

possibility, but you should have plans that cover extreme circumstances.

By definition, events outside of your trading plan are likely to be extreme and it is probably not a good idea to be making unplanned decisions under highly emotional stress.

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Toward a Trading System The tendency for moderate gaps to close may

represent a tradable tendency. Some things to think about:

– Can you execute on the open? – How actively can you / do you wish to trade through the

day? – Can you use successful opening gap trades to trigger

longer-term trades? – What assets can you trade?

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Opening Gap System Ideas Identify opening gaps

– Fixed percentage – Relative to recent gap activity in the market. (Beware of

seasonal influences (e.g., earnings for stocks).)

Are there other factors to consider? – News, volume, other technical factors, trend, range,

volatility.

Test entry strategies – Opening range breakout may make sense. (5-30 minutes).

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Opening Gap System Ideas Where is your initial stop?

– The extreme of the day (high of current day, for a gap up, which is a short entry) is a good place to start

How will you take profits? – Partials? Where?

– 1X risk is always a good place to start Gap closure? Percentage of gap closure?

– Daytrade system or hold overnight component. Check stats and don’t assume.

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My Experience Trading Gaps The edge is there, but it is small. Very competitive market. Mistakes are punished efficiently, so a good goal is to

eliminate as many mistakes as possible. Many events in many stocks trigger on the same day.

– Can filter with a market-relative gap?

Simple is better. Simple is robust.

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Summary Think about why markets gap and how the world

might be changing. Gaps can be emotional events. Gaps can represent both danger and opportunity. There are clear statistics for opening gaps:

– Moderate gaps tend to reverse. – Very large gaps tend to not close. – Very small gaps close nearly always, but this is probably

simply due to noise.

Have a plan.

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Waverly Advisors’ Research Specific systems, broad tendencies, and actionable

ideas in major liquid markets. – Futures – Currencies – Stocks (indexes and individual names)

Both trend-following and counter-trend components. Applicable to traders working on all timeframes.

– Daytraders—swing traders—investors

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Waverly Advisors, LLC: Research Products

Tactical Playbook – Available on Interactive Brokers – Written for the active trader on the daily/weekly timeframes – Exact trade recommendations

Hybrid systematic-discretionary methodology – In-depth technical “drill down” into a set of markets. – Bigger-picture overview of all liquid asset classes.

Tactical Portfolio Outlook – Available on Interactive Brokers – Written for the longer-term manager

Addresses both the allocator and the longer-term active trader. – Emphasis on executing with ETFs in a long-only and long-short environment – Focus on Equities, Equity Sectors, and other asset classes – Macro perspective on risk factors and major economic events.

Options Market Outlook – Contact Waverly Directly – Proprietary, quantitative analysis of options market – Incorporates both volatility and directional analysis – Macro risk factors and cross-asset perspective – Actionable trade ideas

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Contact:

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Waverly Advisors 228 Cedar Street

Corning, NY 14830

(607) 684-5300

www.waverlyadvisors.com info@waverlyadvisors.com

Adam Grimes CIO, Quantitative Analysis, Risk Management grimes@waverlyadvisors.com Chris Noye Managing Director, Head of Sales noye@waverlyadvisors.com