Tuesday, February 19, 2008

An Ugly Gap Failure?

The market gapped up big today but couldn’t hold on to those gains as the S&P 500, Dow 30, and Nasdaq all finished in the red. Reading financial columns tonight you’ll be told that the inability of the market to hold on to its gains was a bad thing. The large black candlesticks are ugly. Market participants are selling into strength. All of which means there is likely more downside to come. But is any of it true?

I ran a study on the Nasdaq 100 tonight to find instances where the index gapped higher by 1% or more and then closed lower on the day. I wanted to see whether the negativity tended to carry through to the next day or next several days. Here’s what I found.

Going back to 1986, the NDX has had 52 occurrences where the market gapped up over 1% and then finished negative on the day. It closed higher the next day 54% of the time. The chance of the NDX being up on any day over the period was also 54%. Over the next 3 and 5 days the chances of the market being higher were 62% and 65% after a large failed gap up. The NDX has closed higher between 55.5% and 56.5% of the time over all 3 and 5 days periods since 1986. So looking out over three and five days the supposedly negative reversal actually seems to be a positive for the market.

Even more compelling is the average gains realized over the period. For the 1-day following the occurrence, the market gained on average 0.4%. An average day in the NDX since 1986 saw a gain of 0.06% - much lower. An average week for the NDX was about a 0.3% gain. The average week after the failed gap up? A 1.3% gain.

If you thought today looked bad and you were worried about the market going forward because of it – you shouldn’t be.


Anonymous said...

Hello Rob,

interesting study, once again. It would be also good to correlate it, if possible, with the volume reading. Yesterday volume was lower than the previous day and substantially lower than the 3-month average. May be, in your study, you could separate the outcome for the to cases: Gap Failure on lower and higher volume.

Incidentally, New Lows have been also lower tha the previous day on NYSE and NASDAQ exchanges. However, it should be noted that, while the level of New Lows is quite comfortable (and below New Highs) for the NYSE, it is not so for the NASDAQ. Also, the New Lows on the Nasdaq are making higher lows while the index is making higher lows also: not good.



Anonymous said...

You've probably answered this question a million times already but:

What program do you use to run your historical studies?

Johan Lindén said...

Thanks for that interesting not, but I would always like to have a bear market filter since most of that measured period was in bull market environment.

A bear market filter could be the 200 SMA or whether the index hit a 52 week high last or a 52 week low last.

But I guess any longer term filter would satisfy.

Rob Hanna said...

Johan -
I ran it above and below the 200 SMA last night and there was no distinguishable difference. It was marginally better below the 200ma.

I use Tradestation for most backtesting.

Thanks for the input. I'll take a look at volume later when I have a chance.


Vishal said...

Very very good info Rob. Thankyou for all your excellent work. So u r saying that filtering this for a bear market made no difference to the success/failure rate and the results ? Interesting.

Anonymous said...

Rob, your analysis is superb. You were spot on how the market would turn out today. How do you run this analysis in Tradestation? Can you give me a hint?

Rob Hanna said...

Daniel -

Dicing the data further creates sample sets that are a little small to draw any concrete conlusions. That said, gap reversals on higher volume appear to provide a greater upside edge than gap reversals on lower volume.

Tommy -

For studies like this I generally create strategies whose triggers mimic current market action. I then use a timed exit to see how the setup has performed in the past.