Wednesday, September 24, 2008

Gaps Stats And How The Lack Of Shorts Could Influence Action

With the gap up on Friday, the 10-day absolute average gap (size without direction) in the SPY peaked at just over 2%. As of Tuesday’s close the reading was down to 1.82%. Tonight as I type the futures are up over 1%, so expect another gap on Wednesday. The 2.01% average is a record. The only other time SPY cam close was after 9/11, when the 10-day absolute average gap hit 1.99%. It actually peaked on 9/24 when the SPY gapped up 2.5% after gapping down 4.74% the previous day (and over 8% down on 9/17 when the market re-opened).

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.


Anonymous said...

Agree with you on the effects of the no shorting rule. I dont remember where, but I read that an exchange in one of the middle eastern states banned short selling, and the market actually moved lower for the next few weeks. Which was contrary to what the guv wanted to happen. Dont know what they could do to stop the beating for specific comp.. maybe put price move limits on those companies like in futures? Just a thought.

Anonymous said...

The low volume is also from people like me that won't trade while the market is broken. I'm not sure I want to trade with a clown like Cox in charge of the SEC even after the ban is lifted. It's become really obvious now that he doesn't understand market structure at all, since they keep saying that they hadn't anticipated the effect that banning shorts would have on market makers. I wonder how many prop trading firms decided to take a two week vacation instead of dealing with a market that has no historical comparisons to backtest against.


Anonymous said...

Besides prudence and risk management concerns another volume factor is that nobody with a sweep that uses ANY of the Reserve funds can get their money to trade.

Every short is an eventual buyer so banning shorting obviously eliminates a large pool of buyers - who typically would buy when it's close to the worst - and that's gonna leave a mark. All gov't intervention in markets makes things worse so no surprise things will be even uglier down the road.

Anonymous said...

It was Pakistan, I believe, which banned short selling. Then they put daily loss limits of 1% in place. When neither of those things worked they banned any kind of selling. I am not sure how they have done since then or if they have lifted the rules at all, but hey Pakistan is a great lead to follow. I hear they are as stable as it gets over there!

Cox is a joke and deserves to be fired.

Marc said...

You would think that a decrease in short sales (as mandated) would create a corresponding decrease in volatility. Yet that is not happening. I'm not sure why. Hmmm.


Tim said...

Shorting was banned in 1930....guess that didn't help.