Gaps - Fade or Follow?

The market myths that many people seem to hold as truth often amaze me. One from an Australian perspective is that if the US Market has a down day (overnight in Australia) the Aussie market will finish lower the next day. No doubt a similar belief may be held in the States regarding Australian and Asian markets, though I am sure their movements are far less publicized.

In this circumstance it is certainly fair to say that Australian stocks and indices will open lower - that is not in question. What is in question is whether they will trade lower from there. This is not to say that the US and Australian Equity Markets are not highly correlated from a big picture perspective – quite clearly they are. It is to say that if predicting Aussie Market direction was as easy as looking at what the US did overnight, surely trading such a strategy would be like shooting fish in a barrel!

With all that in mind I have conducted a small study to establish just how the market continues in the direction of a gap – up or down – from the open. To do this I ran a number of simple system tests. All were conducted over the last 12 months. The systems bought to enter on a gap up at open and sold to enter on a gap down at open. All positions were exited at the close of each day.

The first test used the day only session of the SPI 200 Index Futures. As many will be aware the SPI also has a night session which is very heavily influenced by Europe and then the US. If the US is down, the night market follows it to a lower open on the day session the next day.

In the second test I used a list of 10 major ASX stocks and simply bought or sold them based on the above entry and exit criteria.

For the purpose of the test a gap up was defined as an open higher than the previous day’s high and a gap down defined as an open lower than the previous days’ low. Chart 1 highlights gaps up in green and gaps down in red.

Chart 1

click to enlarge

Table 1 summarizes the results of the tests, broken down by gap direction and test list. It is very clear that gaps on open do not predict market direction for the rest of the day. On average, gaps up result in the market finishing slightly lower and gaps down result in the market finishing slightly higher.

Table 1

From my viewpoint the results speak for themselves. If anything Australian stocks are more likely to trade in the opposite direction to the US on a day by day basis.

It is always important to acknowledge any additional considerations or possible improvements to a test. On that note, a larger test period could be used. In which case the percentage of up days after a gap up could well increase considering the predominantly bearish movements over the last 12 months. However I wouldn’t expect this to be drastically different. Last, while I am happy with the premise that stock markets will most often open lower or higher due to overseas movements, a filter could be applied to remove announcements and news for individual stocks.

So with all that in mind the results certainly suggest it is better to avoid following overnight gaps. In the immortal words of a famous TV show, “I think we can call that myth busted!”

Happy Trading

Jordan Craw