Big Gaps (Can) Mean Big Profits

02/15/2012 8:30 am EST

Focus: STRATEGIES

Scott Andrews

CEO & Co-Founder, InvestiQuant

Large and more infrequent "monster gaps" are scary and require a safer approach, explains Scott Andrews, but because of their big profit potential, traders may not want to simply avoid them.

We’re taking a look at big gaps with Scott Andrews. Let’s talk about large and “monster” gaps. First, give me a definition of what they are.

Well I have a single line I draw every day: I’m looking at whether or not the gap is above or below 40% of the five-day average true range (ATR). It’s a really good delineator, statistically.

It makes a big difference if the gap is smaller than that; I call those small or mid-sized gaps. Those have a much higher probability of filling.

If they’re above that, then they’re larger and they generally have a much lower probability of filling.

In fact, on this slide here, you can see this is the opening gap in the Spyder Trust (SPY). Since 2002, there have been 500+ large gaps greater than 40% of the five-day ATR, and you can see, I’ve circled that about 52% of those will actually retrace and fill the gap back to the prior day’s close.

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Less than half of these fill, which is lower than my desired win rate.

It certainly makes them riskier, and you can also see just naturally, the ones that didn’t fill would have cost you money; you would have lost money had you traded every single one of them.

So, normally it begs the question, well, why don’t you just use a stop and limit your losses?

This next slide actually applies my “benchmark stop,” I’d call it; 30% of the five-day average true range. Again, using that five-day volatility measure, if you were to apply a stop, as you can see, the win rate drops a lot. The average win rate is about 35%.

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So, the large gaps are only going to be what I would consider tradable for profit about a third of the time, and that’s certainly not good enough.

Now that begs the question why bother fading them? Maybe you should follow them, as they say, and if you look on the far right, it’s not a really good idea because fading them is terrible.

The far right shows the up gaps, and the short trades are especially dangerous, historically, especially the large ones.

I think it’s a combination of folks who have been short are forced to cover. They buy and bid up the market on those large up gaps. It builds and gains momentum, and you’ve got speculative buyers, right?

The markets have an inherent bias to the long side, so only 31% of the big up gaps have filled, historically, and since that’s the scenario and I’m a fader, I generally short up gaps and buy down gaps, but that’s the one scenario—large up gaps—when I start thinking about following the gap or going with the direction of the gap.

NEXT: "Monster Gaps" Can Be Scary, But Very Lucrative

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Well what about “monster gaps,” and what is a “monster gap?”

Well, a monster gap sounds scary, and it’s really not. That’s why I call them monster gaps; it helps me remember not to be scared, so it’s my play on words here. But they are any gaps larger than one time the size of the five-day average true range; that’s a pretty large gap.

Right now the current five-day ATR in the Spyder is something like 25, so a $2.50 gap or bigger would be considered a monster gap.

There have only been 26 of those in the past seven years, so they don’t happen that frequently; just a few of them a year.

A lot of traders run from them, and I don’t like them because of the win rate. The win rate is actually less than 50%, but the payoff is huge.

What’s interesting is that there is not a direct relationship between the size of the gap once you get to a certain size—that 40% of the five-day ATR—once you get above that, pretty much the win rate is the same on all of them, so as they become bigger, the payoff is much bigger and it more than compensates for those that you’re going to get stopped out on.

So, this actually shows you would have made three times as much or more in profits fading those large up gaps.

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Generally, what I tell people is to reduce position size because the win rate is much lower, and you may want to scale out to lock in a profit if you get a partial gap, fill but always consider holding some of that position because even if it looks like there is no way it could ever fill, often they will.

What about the stop? Where do you put that, and how do you manage your risk?

I still stick with the same size stop, 30% of the five-day average true range. It seems to do a good job of capturing.

If they’re going to fill, they’re not going to move too far against you most of the time. So, you’ve got to control your risk in some way. It reduces the win rate about 10% there as well.

And where can I find some of this information?

I know it’s a little bit hard to read here, but it’s easy to read at TheGapGuide.com. I’ve got a bunch of free research there on opening gaps.

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