Last winter I did several posts on playing gaps. Two of particular interest may be the large gaps up and large gaps down posts. In those I found that when the market was in a long-term downtrend large gaps in either direction had a tendency to lead to gains from open to close.
The upside edge for large gaps down was likely due to the fact that the move was an overreaction and the retail traders got fleeced. The sharp morning drop may have allowed a temporary panic bottom to form and the market to move higher as the day wore on.
The upside edge for large gaps higher often comes from the fact that the shorts just got trapped. They need to cover their positions and are forced to chase as the market moves against them. These bear traps have often come following a Fed or other government announcement. The massive gap up on Friday was engineered with perfect timing for a short squeeze since it was expiration Friday. Adam Warner did a nice job of explaining the impact of the timing in a recent post.
I’m most interested in watching reactions to large gaps up in the coming days and weeks. With their new rule prohibiting short sales in a large number of stocks, it would seem the government has taken away some potential explosiveness. If no one is chasing the gaps and bounces higher, the rally loses a good number of potential buyers.
In fact, the lack of short-coverers may partially explain the recent pullback. Volume has contracted greatly and the pullback has given back gains faster then any other. Under normal circumstances there likely would have been more volume and more support as the shorts that didn’t chase start covering when then market begins to pull back. With reduced explosiveness and less support, the elimination of shorts could actually make the bottoming process more difficult. At the very least it may change the shape of the bottom. It will certainly be interesting to watch and trade.