Friday, May 08, 2009

Large Opening Gaps to the Upside: What Comes Next?

Do gaps tend to fill, or do we tend to see follow through in price movement when the stock market opens higher or lower from its previous day's close?

I went back to 2005 (N = 1093 trading days) and measured the opening gap in the S&P 500 Index (SPY) as a function of the prior 20-day average trading range. We can call this the "relative gap", because we're measuring the size of the gap as adjusted for the volatility of the market trading at that time.

I decided to investigate relative gap rather than absolute gap, given my prior findings that absolute gap size on an upside open was not particularly predictive of markets going forward.

When the opening gap was .50% or greater (i.e., when the difference between the market's open and its prior close was half or more of the average daily trading range and the gap was to the upside), the move from that open to the market close averaged a gain of .47% (47 instances up, 27 down). Interestingly, by the *following* day's close, that edge had evaporated, as the market's average gain eroded to .11% (39 instances up, 35 down).

(Note: We would need to see an opening gap of roughly 1.15% to correspond to the above criterion in today's market).

When the opening upside gap occurred following a down day in SPY, the average move from that open to the day's close averaged a gain of .68% (27 up, 15 down). When the strong opening gap followed an up day in SPY, the average move from open to close averaged a gain of only .19% (20 up, 12 down).

This is a theme I'll be touching upon in future posts: the expectations following a given day's activity depends in part upon the context--the prior pattern of activity--in which the day is situated. A strong market that follows strength may have different expectations than a strong market that follows weakness.

It may be more helpful to view gap relative to current volatility than in absolute point or percentage terms.