Monday, April 27, 2009

Putting Large Gaps Down Into Context

As I am writing this late Sunday night the S&P futures are down close to 2%. Large gaps are often seen as fading opportunities by traders. This is due to the propensity of the market to reverse gaps. In a study I posted to the blog a few weeks ago, I showed that the propensity of the market to either reverse or follow through on gaps up of 1% up or greater depended largely upon the action leading up to the gap. I have found a similar dependency when looking at gaps down.

Below are the results of a system that looks to purchase $100k of SPY any time it gaps lower by 1% or more and HASN’T closed higher for 2 days in a row. The trade is exited at the close of the day. As you can see, reversals are slightly favored and the net expectation is for further upside. (1998-present.) Click any of the images below to enlarge.

But what about those times like now where the SPY has closed higher for 2 days in a row? Those results are below:

In this case results appear to go from somewhat bullish to strongly bearish. An overbought market that gaps down big tends to sell off further. Below is an equity curve of the system.

As you can see the downside tendency has been quite consistent.

Lastly, I also looked at gaps down following at least two down days in a row. Those results are below:

Here you see that although it’s a 50/50 proposition, the rewards outweigh the risks by a large degree. Of course since Monday’s potential gap down would be coming after two up days, the net expectation would favor more downside.

To best understand the meaning of a pattern, it often helps to take it in context. Gaps are no exception.


Shanky said...

Nice analysis as always, but this gap has a "reason" or external ignition as I like to call it. It is also occurring in an extremely overbought market as we all know. This would lead me to avoid the buy the dip scenario this time. This is good data to keep in the back pocket though. Thanks.

Douglas said...

there is always a 'reason'.

Long live the 'reasons'.

They keep the crowd dependent on their subjective opinions and emotions and leave the money with the number crunchers.

Yum yum. Feast for bears coming up.

tr said...

Thank you for all your posts, I read them daily although I don’t comment often. I don’t know if you would be comfortable sharing which software you use to run these historical analyses and simulations, but if you would be so kind as to share, I would very much like to know. If not, no hard feelings :-)

Thank you!

Anonymous said...

nice call again

as of this writing, 10:47 am est, the market's are positive

it really amazes me that EVERYWHERE i look, message boards, chatrooms, blogs, etc etc, EVERYONE and their mothers think the market's going down tomorrorw, and the day after that

until june/july of 2008, people were itching to call the bottom

now, people are itching to call the tops

the first 2 posters above clearly show that sentiment

who knows, maybe this IS a botttom

i dont care for a bull market

i just hope the low holds

or at least we dont go much lower than that

but honestly, it is very hard to believe this is the bottom, and im hoping that will make it the bottom

Douglas said...


You are right. I partly express the bearish sentiment for my own amusement. I have been bitten in the backside most of the way up this rally - and I have been consistently confident that we are at or near the intermediate top.

I will not define myself as wrong for a while yet as I am working over longer time frames with peanuts on my trades.

I made my peanuts on the way down from January but I was wrong about the 666 bottom. I expected a fear spike but that never came and am looking at sentiment patterns in a greater light now.

However, in the run up to early March I did notice quite a lot of 'is this the bottom', 'it must be just round the corner' chat - and they were right.

Maybe we read different blogs. I entirely ignore the mainstream media stuff except for the occasional laugh at Cramer as I regard them all as knuckle draggers.

My view is that almost everyone is wrong most of the time.
Most people are wrong almost all of the time
And the shining elite are right nearly half of the time.

I regard myself and the bloggers that I read as being in that final category.

Rob is near the top.

Anonymous said...

douglas, i am also one of the people that have been skeptical of the rally

this morning, at around 9:50am et, i shorted the s&p at 857.50 expecting the markets to reach 848

it never happend and i was stopped out with a profit

when it pierced above 858 on the way back up, i knew, or i thought, it was going to make a new high and that's when i came onto this blog and posted my message

i would have gone long again when it came back down to that level but i wasn't on my desk

now that the market has breached that same level, i remain bearish for the 28th

i focus on the intraday

what you say about bearish sentiment, however, is something that i see everywhere, not from just the "top elite" blogs

and even if this blog was one of the best there is, everyone has access to it, and therefore makes its calls worth LESS

here's the problem

mainstreet IS reading and searching the blogs for trading information

jim cramer is teaching technical analysis on his show, and techincal analyssi books have entered the top 20 bestsellers in amazon

i've always told myself technical analyssi would come to its end when i saw a chartist book in the top 20

and it's happned

you show 2 chartists the same chart and they WILL come up with a similar conclusion

everyone will lay out their fibonaccis, stochastics, and trendlines left and right and it's not uncommon for them to reach the same conclusion

you are right, turns in the markets are made because least amoutn of people expect it

but now, with everyone focused on the same source(blogs, charts, books, etc), whatever future projectiion that is presented in the chart is already expected

you say the mainstream is bullish right now?

i dont know about you but when i see art cashin calling for a top on cnbc every freaking morning i dont think that is the "shining elite" opinion