Greed and Fear - Daily trading signals based on mathematics and software, no opinion, no emotion, no ego.

mind the gap1"Mind the gap" may be a useful warning on airports and train stations, but is it any good in short term trading? As traders we have all heard this general trading wisdom that says 'gaps get closed'. But are they? And also, let's be more specific about when they get closed. Is it the next day, next week or next year a gap gets closed?

Let's first start with what we define as gaps on a daily chart:

  • Upward gap on a daily chart: the intra day low of a trading day is higher than the intra day high of the previous trading day.
  • Downward gap on a daily chart: the intra day high of a trading day is lower than the intra day low of the previous trading day.

Of course gaps may exist on every time frame, but in this case we are only looking at the daily time frame because that's where this gap-closing-trading-wisdom has its origin. And since trading is inherently short term, we are going to look at what happened within the next 10 trading sessions after a gap was formed. It is of no use to take this to several weeks or even months when trading things like futures or options. A short term trader is looking for an edge in the next few days. So is there a short term edge in trading gaps?

We are going to look at the S&P 500 for the last 50 years, that's roughly 13000 trading days. The first table shows that there have been 105 upward gaps during that period. Next in the table, you will find the numbers showing how many gaps have been closed and on which day.

upward gaps closed the next day closed 2nd day ... 3rd day ... 4th day ... 5th day 6th 7th 8th 9th 10th
105 25 8 8 3 4 3 3 2 5 2

So 10 trading days following the upward gap, 63 (=25+8+8+3+4+3+3+2+5+2) of the 105 have been closed. 

Let's now look at the downward gap: 

downward gaps closed the next day closed 2nd day ... 3rd day ... 4th day ... 5th day 6th 7th 8th 9th 10th
 59 9  11 6 2 4 3 2 2 3 3

In 10 trading days following the downward gap, 45 (=9+11+6+2+4+3+2+2+3+3) gaps of the 59 have been closed.

Also note that the total number of gaps is 164 (=105+59) which is only 1,26% of all trading days in this (huge) sample. So by that number alone, trading gaps on the S&P 500 doesn't have any real significance. It is probably wiser to search for other trading patterns and set ups that can be used more often than once every 80 days on average, although I must add that half of these gaps took place in the last 10 years.

So what should a trader do the day after a gap has been formed? Expect gap closing or the opposite? The numbers above speak for themselves. Some statements can be done based on these numbers:

  • 24% of upward gaps are closed the next session.
  • 15% of downward gaps are closed the next session.
  • 50% of upward gaps are closed in 6 days.
  • After 10 days 63% of upward gaps are closed.
  • 50% of downward gaps are closed in 4 days.
  • After 10 days 76% of downward gaps are closed.
  • Gap closing has a bullish bias.

This leads us to the following trading recommendation:

  • The most favorable trade right after the gap would be to trade with the direction of the gap, not against it(!). This means: long-positioned after an upward gap and short-positioned after a downward gap.
  • The most favorable trade with a 10-day horizon after a gap is to trade against the direction of the gap. Gap closing is the most likely scenario within a 10-day period. This means: short-positioned after an upward gap, long-positioned after a downward gap. Obviously these positions should be taken a few days after the gap to eliminate some risk of being stopped out in the mean time.
  • The most favorable gap to trade is the downward gap. It has a higher probability move on the next day after the gap (a close is less likely), and has a quicker and higher probability in closing the gap.

So is the gap-closing-trading-wisdom true or false? Since it didn't specify a time horizon, generally we could say the claim holds true, but maybe in a different way than most market commentators think of.

These numbers can not be easily compared to the numbers mentioned in The Encyclopedia of Chart Patterns by Thomas Bulkowski (it's in my bookstore). In this massive book on page 362 the author discusses several types of gaps, but in my opinion does not clearly specify how to distinct between these several gap types (another example of why technical analysis is not science). In his study, some types of gaps could take up to 168 days(!) on average to close (break away gaps). Another thing to note is that Bulkowski has looked at individual stocks, while this article is about an index (S&P 500). However I do like his idea about looking at gap-behavior in bull and bear market situations. Unfortunately he did not specify the exact bull or bear market criteria. Still, The Encyclopedia of Chart Patterns is of course an excellent book and a must have for any trader.

The next thing I would like to see is how a European index behaves with respect to gaps. Because of the time-difference between these markets (US vs EU), gaps will come up on completely different days and may behave in a different way. Let's find out by having a look at the Dutch AEX. In my database, I have data going back to 1992 which comes down to 5359 trading days at this moment of writing.

upward gaps closed the next day closed 2nd day ... 3rd day ... 4th day ... 5th day 6th 7th 8th 9th 10th
 526  139  69 35   22  18 13   10  14  7  5

 

downward gaps closed the next day closed 2nd day ... 3rd day ... 4th day ... 5th day 6th 7th 8th 9th 10th
358   111  51  37  17 14  14  12   5  9  4

The first very obvious difference with the S&P 500 is the number of gaps on the AEX. Over 16% of its trading days have gaps(!) To sum it up:

  • 26% of upward gaps are closed the next session.
  • 31% of downward gaps are closed the next session.
  • 50% of upward gaps are closed in 4 days
  • After 10 days 63% of upward gaps are closed.
  • 50% of downward gaps are closed in 3 days.
  • After 10 days 76% of downward gaps are closed.
  • Gap closing has a bullish bias.

Even though the AEX has many more gaps, these percentages show great similarities with the S&P data. The conclusion stays the same: trade with the gap the first day, but expect a close within 10 days.