Trading Opening Gaps to the Upside

A few notes before we start the first trading session of 2007. As of my writing (5 AM CT), we'll see a large upside gap in the ES futures. Below we'll take a look at what has happened recently following large gaps to the upside.

First, though, I want to thank readers for their interest in the selected 2006 posts. In case you missed those links, here are the trading and market psychology posts from the first half of the year, from the third quarter, and from the fourth quarter.

Also take a look at the Trader Performance page of my personal site. The latest entry links the Peak Performance Seminar that I participated in for the Chicago Mercantile Exchange and discusses trading goals for 2007.

Finally, I'll be using the Trading Psychology Weblog during 2007 to summarize my trading outlook at the start of each session. I'll review the research and indicators I've found to be useful and try to put them in a coherent picture for the next trading day.

So now let's look at large opening gaps to the upside. I went back to 2004 (N = 752 trading days) in the S&P 500 Index (SPY) and found 76 occasions in which the upside gap was more than 40% of the average daily trading range from the previous 20 sessions. Interestingly, there was no directional edge from the open to close. The average price change following the upward gap was -.07% (37 up, 39 down). In all, 25 of the 76 sessions completely or substantially closed that opening gap.

When we look beyond the day session (open to close), however, we see a more bullish pattern. Specifically, if we look at the market close two days following the large gap opening, the average gain has been .23% (47 up, 29 down), quite a bit larger than the average two-day change of .07% (414 up, 338 down) for the sample overall. Almost all of that gain, however, has occurred when the upside gap has followed a winning trading session (N = 27); the average gain has been a sizable .48% (20 up, 7 down). When the upside gap has followed a losing session (N = 49)--as is the case this AM--the average two-day gain is only .09% (27 up, 22 down). That represents no distinct edge.

The pattern suggests that upside gaps may be most valuable when they are part of a bullish market, contributing to an upside momentum effect. When the upside gap is making up ground lost in the prior session, near-term results have not shown a meaningful directional bias. It might be possible to screen for stocks that are bullish the previous day and that gap upward the following session to take advantage of upside momentum. Indeed, if I'm not mistaken, we see some trader-bloggers making good use of just such a pattern. More on this gap trading strategy to come!

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