A Day Trading Strategy: The Gap System

Michael Tan, Ph.D., CFA

Copyright 2005 Michael Tan, Ph.D., CFA

Apothem Capital Management, LLC
330 East
E t 38th Street
St t 14L
New York, NY 10016
Tel: 212-922-1265
[email protected]
All rights reserved

Trading stocks on days when they have a massive opening gap

One casually observes that a stock opening up or down several times its average daily price
movement tends to be actively traded early in the day and move in big intraday trends.

We hypothesize the following:

1.

Since the gap is due to an information innovation, i.e. an unexpected and dramatic stockspecific event, the opening price is likely to be wrong.

2.

The larger the opening gap, the greater the uncertainty in the opening price and the
greater the chance of it being wrong.

3.

The market then adjusts by trending to the right price over the course of the day.

4.

The increased liquidity demands amplify the trends much more than on no-gap days,
allowing them to be traded profitably.

Using trading strategies as statistical diagnostics, we study the post-gap price behavior of several
hundred large cap stocks. We determine if post-gap prices tend to travel in the direction of the gap
or counter to it.

Do post-gap prices follow the gap or counter it?

The simplest strategy is to buy a stock when it gapped up and short it when it gapped down. This
assumes that the market tends to underreact to the information that produced the gap.

The following Follow Gap At Open strategy is backtested using 1-minute bars on 231 large cap
stocks from 7/3/2002 to 2/17/2005:
Long strategy:
If the difference between the opening price and the previous days close is greater than 2.75 times the exponential
average of the absolute daily close-to-close changes (with a 0.01 smoothing factor), then buy 1 minute after the opening.
Sell out the position if the price breaks a 15-minute low.
Short strategy:
gy
If the difference between the opening price and the previous days close is less than -2.75 times the exponential average
of the absolute daily close-to-close changes (with a 0.01 smoothing factor), then sell short 1 minute after the opening.
Buy to cover the position if the price breaks a 15-minute high.
Only one trade is permitted on any given day.

Gap System (Follow Break At Open)

Mean gross profit per 2 shares traded
Mean gross profit per share per round turn (long trades only)
Mean gross profit per share per round turn (short trades only)
Mean trade duration (minutes)
Max trade duration (minutes)
Success rate (gross profit)
Success rate (long trades, gross profit)
Success rate (short trades, gross profit)
Win/loss ratio (gross)

$0.033
$0.021
$0.045
31
167
44%
48%
45%
1.1

The direction of the opening gap is not a good trading signal

The Follow Gap At Open strategy is neither profitable nor consistent enough to be traded in practice.
The $0.033 gross profit per round turn may not be viable after slippage costs.

Although prices do follow the opening gap more often than not, the direction of the gap on its own is
not a g
good trading
g signal.
g
Gap System (Follow Break At Open), $0.01/sh RT TC, $1M face/trade, $4M notional, DayTrad
1M
3M
6M
9M
12M
24M
36M
min
max
std
r/r
%pos
%neg
avg+
avgavg

-4.39
11.55
3.34
0.16
0.5
0.5
2.89
-1.84
0.52

-6.33
7.43
4.29
0.66
0.68
0.32
4.13
-3.64
1.63

-9.23
12.99
5.05
1.72
0.8
0.2
5.16
-2.93
3.54

-5.73
18.03
6.6
2.25
0.68
0.32
8.69
-3.04
4.96

-5.67
17.26
7.07
3.21
0.84
0.16
8.33
-2.97
6.54

Annual:
2002
2003
2004
2005
CARR
R/R
skew
STD

-5.26
1.71
12.12
1.19
8.37
0.71
1 23
1.23
11.86

5 worst drawdowns:
DD
1
2
3
4
5

Avg DD:

-10.46
-5.48
-4.98
-2.44
-1.19

-4.91

Begin

End

20030429
20031031
20041029
20021127
20040528

20030930
20040430
20041129
20030226
20040630

Dur(M)

Recovery
8
9
2
5
2

2
4
0
3
2

11.59
18.46
2.41
28.96
1
0
14.24
14.24

0
0
0
0
0
0
0
0
0

The Follow Gap Breakout from Opening Range Strategy

The key to trading opening gaps is to define an opening range.

The market heuristic is that in the first few minutes after a gap opening, market participants sort out
the direction in which the stock price will move.

The opening range is the bracket formed by the highest and lowest prices transacted during these
few minutes.

A decisive breakout from the opening range determines the direction of adjustment to the right
price given the information innovation that caused the opening gap.

The opening range

helps filter out false
reversals and false
follow throughs after
the opening gap.

The opening range dramatically improves trading of opening gaps

The Follow Gap Breakout from Opening Range Strategy incorporates the opening range as
described below:
The opening range is defined to be the highest and lowest prices observed in the first 10 minutes of the trading session.
Long strategy:
If the difference between the opening price and the previous days close is greater than 2.75 times the exponential
average of the absolute daily close-to-close changes (with a 0.01 smoothing factor), then wait for the opening range to
be established and buy on a stop price equal to the high of the opening range. If a position is established, sell it out if the
price breaks a 15-minute low.
Short strategy:
If the
th difference
diff
b
between
t
th
the opening
i price
i and
d th
the previous
i
d
days
close
l
iis lless th
than -2.75
2 75 titimes th
the exponential
ti l average
of the absolute daily close-to-close changes (with a 0.01 smoothing factor), then wait for the opening range to be
established and sell short on a stop price equal to the low of the opening range. If a position is estabished, buy to cover
it if the price breaks a 15-minute high.
At most one trade is permitted on any given day.

The idea is that a breakout from the opening range in the same direction as the opening gap
confirms the trading signal.

The opening range dramatically improves trading of opening gaps

The Follow Gap Breakout from Opening Range Strategy has an admirable success rate (insofar as
it is a trend following strategy) and a very high win/loss ratio:

Gap System (follow gap,

gap breakout from opening range)
Mean gross profit per round turn
Mean gross profit per share per round turn (long trades only)
Mean gross profit per share per round turn (short trades only)
Mean trade duration (minutes)
Max trade duration (minutes)
Success rate (gross profit)
Success rate (long trades, gross profit)
Success rate (short trades, gross profit)
Win/loss ratio (gross)
Average # trades per day (for 231 stocks)

$0.107
$0.100
$0.115
28
149
50%
54%
49%
2.0
2

A gross profit of $0.11 per

share is likely to be viable
after slippage costs.

The opening range dramatically improves trading of opening gaps

A gross profit of $0.11 per share is exciting because of the fabulous advantages of day trades:
1.

No overnight/gap risk

2.

No need to finance positions means extra return from not having to pay the debit/credit
spread

3.

Practically infinite intraday leverage

4.

P/L is clean since there are no dividends and other accruals.

Gap System (follow gap, breakout from OR), $0.01/sh RT TC, $1M face/trade, $4 mil notional
1M
3M
6M
9M
12M
24M
36M
min
max
std
r/r
%pos
%neg
avg+
avgavg

-1.25
6.59
1.99
0.75
0.77
0.23
2.1
-0.47
1.5

-1.4
9.2
2.38
3.39
0.93
0.07
5.06
-0.7
4.65

0.95
15.41
3.47
6.43
1
0
9.12

7.19
19.54
3.57
11.64
1
0
13.86

13.45
22.85
3.21
20.24
1
0
18.77

33.81
39.89
2.51
71.55
1
0
36.63

9.12

13.86

18.77

36.63

Annual:
2002
2003
2004
2005
CARR
R/R
skew
STD

8.85 half year return

14.42
22.81
0.79
17.51
2.56
1.09
6.83

5 worst drawdowns:
DD
1
2

Avg DD:

B i
Begin

E d
End

-1.4 20021129 20030331

-1.25 20050131 20050131

-1.32

D (M)
Dur(M)

R
Recovery
6
0

3
0

0
0
0
0
0
0
0
0
0

A high
g S
Sharpe
a pe ratio
at o a
and
d low
o
drawdowns are hallmarks of
this strategy.

Opening range without conditioning on gap does not work

As a control, we backtest a strategy that trades the breakout from the opening range every day
without conditioning on the occurrence of an opening gap.

The strategy is as follows:

The opening range is defined as the highest and lowest prices observed in the first 10 minutes of the trading session
session.
Long strategy:
Wait for the opening range to be established and buy on a stop price equal to the high of the opening range. If a position
is established, sell it out the position if the price breaks a 15-minute low.
Short strategy:
Wait for the opening range to be established and sell short on a stop price equal to the low of the opening range. If a
position is estabished, buy to cover it if the price breaks a 15-minute high.
At most one trade is permitted on any given day.

This strategy is not profitable after assumed transaction costs. This attests to the efficacy of the
dual conditon of gapping and breaking out of the opening range.

Gap System (breakout from opening range, no gap condition)

Mean gross profit per 2 shares traded
Mean gross profit per share per round turn (long trades only)
Mean gross profit per share per round turn (short trades only)
Mean trade duration (minutes)
Max trade duration (minutes)
Success rate (gross profit)
Success rate (long trades, gross profit)
Success rate (short trades, gross profit)
Win/loss ratio (gross)
Average # trades per day (for 231 stocks)

$0.013
$0.010
$0.015
24
223
39%
38%
39%
1.1
311

The Counter Gap Breakout from Opening Range Strategy

A breakout from the opening range in the direction opposite to that of the opening gap can
sometimes be a good reversal signal.

This Counter Gap Breakout from Opening Range Strategy is as follows:

The opening range is defined to be the highest and lowest prices observed in the first 10 minutes of the trading session
session.
Long strategy:
If the difference between the opening price and the previous days close is greater than 2.75 times the exponential
average of the absolute daily close-to-close changes (with a 0.01 smoothing factor), then wait for the opening range to
be established and sell short on a stop price equal to the low of the opening range. If a position is established, buy it to
price breaks a 15-minute high.
g
cover if the p
Short strategy:
If the difference between the opening price and the previous days close is less than -2.75 times the exponential average
of the absolute daily close-to-close changes (with a 0.01 smoothing factor), then wait for the opening range to be
established and buy on a stop price equal to the high of the opening range. If a position is estabished, sell it out if the
price breaks a 15-minute low.
At most one trade is permitted on any given day.
Gap System (counter gap, breakout from opening range)
Mean gross profit per round turn
Mean gross profit per share per round turn (long trades only)
Mean gross profit per share per round turn (short trades only)
Mean trade duration (minutes)
a ttrade
ade du
duration
at o ((minutes)
utes)
Max
Success rate (gross profit)
Success rate (long trades, gross profit)
Success rate (short trades, gross profit)
Win/loss ratio (gross)
Average # trades per day (for 231 stocks)

$0.057
$0.057
$0.056
26
139
39
44%
41%
45%
1.4
2

Schema for the Gap Strategies

The schema are shown for a gap down scenario only. The schema for the gap up scenario is
entirely analogous.
buy on breakout to

yesterdays
close

moderately
profitable

buy on breakout to
upside of opening
range

opening
gap

not
profitable
fit bl

upside of opening
range
not
considered
an opening
gap

todays
open

opening
range

Sell short on breakout

to downside of opening
range
todays
open
p

todays
open
p

opening
range
g

not
profitable

sell
short

marginally
profitable

sell short on breakout

to downside of opening
range

Consistently
very profitable

Note that buy on breakout to upside

of opening range after a gap-up
open is also consistently very
profitable.

Increase profits by combining Follow Gap and Counter Gap strategies

The Follow Gap Breakout from Opening Range and the Counter Gap Breakout from Opening Range
strategies are not logical opposites (the fact that one makes money does not mean the other will
lose money).

Combining both strategies increases profits because the number of trading opportunities per day
increases.
Gap System (follow and counter gap, breakout from OR), $0.01/sh RT TC, $1M face/trade, $4
1M
3M
6M
9M
12M
24M
36M
min
max
std
r/r
%pos
%neg
avg+
avgavg

-1.66
9.65
2.77
0.67
0.73
0.27
2.8
-0.75
1.85

-3.33
13.58
4.14
2.33
0.89
0.11
6.51
-2.36
5.56

-1.24
20.85
6.55
4.09
0.92
0.08
11.95
-0.77
10.94

1.78
28.37
8.4
5.84
1
0
16.35

6.97
34.66
9.41
8.15
1
0
22.14

37.97
50.27
4.72
45.3
1
0
43.62

16.35

22.14

43.62

Annual:
2002
2003
2004
2005
CARR
R/R
skew
STD

18.59 half year return

11.13
32.98
3.09
21.46
2.26
1.24
9.52

5 worst drawdowns:
DD

Begin

End

Dur(M)

Recovery

Gap System (follow and counter gap, breakout from opening range)
Mean gross profit per round turn
Mean gross profit per share per round turn (long trades only)
Mean gross profit per share per round turn (short trades only)
Mean trade duration (minutes)
Max trade duration (minutes)
Success rate (gross profit)
Success rate (long trades, gross profit)
Success rate (short trades, gross profit)
Win/loss ratio (gross)
Average # trades per day (for 231 stocks)

$0.080
$0.078
$0.083
27
149
47%
47%
47%
1.7
3

1
2

Avg DD:

-3.33 20021129 20030630

-1.66 20050131 20050131

-2 5
-2.5

11
0

7
0

0
0
0
0
0
0
0
0
0

Minimizing slippage is key to success of the Gap Strategies

The Gap Strategies are truly statistical strategies, since gaps only occur sparingly on any given
stock, but there are on average about 1 gap per 100 stocks per day.

It is hard to judge whether the strategy works when it is tested only it on one stock. When it is
applied to many stocks, one gets a statistically steady stream of profits even though the trading
jumps from stock to stock.

While the Gap Strategies are simple, their implementation must be sophisticated since minimizing
slippage is the key to their success.

I surmise that by tracking tick

tick-by-tick
by tick prices
prices, it is possible to discern very short term liquidity flows on
the scale of seconds. This information can be used to improve the execution of stop orders.