Gap Personality: When to Chase and When to Hold Off

• Posted by DynamicHedge
• on June 13th, 2014

Gaps are one of the last bastions of structural inefficiency in the market and we’ve seen a ton of them lately in popular momentum stocks. Gaps are formed because there’s roughly 17.5 hours of potential market moving information between the close and the open and no liquid market where price can find equilibrium.  The information that moved the market overnight usually creates a state of disequilibrium in the initial minutes/hours/days (depending on the news). This disequilibrium can unlock profitable opportunities if you understand the dynamics of price action in the wake of the news.

The biggest issue is how these trades act. Any excel table can tell you where a series of trades ended up, but it’s a lot harder to tell you HOW they got there. I would rather know in advance which trades have the best chance of working out and only take the highest probability opportunities and be able to see the patterns unfolding. A gap higher is not the same as a gap lower and different companies have different shareholder bases which may react differently to adverse or positive news in their stock.

Below is $LULU which reported terrible earnings.

Long-term bears are probably covering shorts. Long-term bulls are looking at this as an amazing buying opportunity. Short-term traders who were long into earnings are in a world of hurt. How all these various players with different time frames and motivations play off one another is how charts get formed.

So we plug the data into Market Memory and see how this has played out in the past (query is for all gaps lower than -6%).

 

The most dominant price action is continued downside so caution is clearly warranted if you’re looking to buy this stock. The second most dominant pattern shows a bounce after around 5-days of selling. That might be a good game plan if you’re constructive on the future. If you’re simply a day trader it might make sense to join in on the downside and take a short position. How you use the information in the Alpha Curves depends on your overall opinion of the stock. There are even a small handful of times where buying the opening print on the gap results in nearly optimal entry, but this is rare and not repeatable.

Now we have $YELP and the same situation only in the reverse configuration. There was positive news in the sector ($OPEN was bought out by $PCLN) and the stock opened significantly higher.

Bears are suddenly dead, bulls are pounding their chest, etc. Take a step back and examine how this situation has played out in the past (query is for all gaps higher than 6%).

 

Over the course of 40-days only 50% of the instances in the study ended higher! How’s that for something your shouldn’t chase? However, when we observe the Alpha Curves we can see there is a clear edge in buying deep pullbacks around day 7 or 17. There is no indication that it is typical for $YELP to gap higher and run without you. Could it happen? Sure. Is it repeatable? Absolutely not.

When the market is moving and feels like you’re getting a rare opportunity at a discounted price or the market might run away from you and never come back again, it’s always good to have some perspective from the past to guide your decisions going forward.

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Data is courtesy of https://www.marketmemory.com/

 

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