The Gap Myth

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 down day (overnight in Australia) the Aussie market will finish lower the next day. No doubt a similar myth may exist in the States regarding Europe or Asian and Australian markets, though I am sure the movements of the latter 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 also 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 often 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 24 months from February 22nd. 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 the same day.

The first test used the day only session of the SPI 200 Index Futures, a futures contract based on the S&P ASX 200 Index that tracks Australia’s largest 200 stocks by market capitalization. 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 which in turn gives 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.

Table 1

The results speak for themselves. The only scenario that managed a better than 50% hit rate (just) was a gap down on the major ASX stocks. However the average movement of those days still ended up positive – against the direction of the gap. Trading in the direction of a gap up on the SPI 200 yielded the worst result. This is something that should be especially noted not just by those trading the SPI, but also those trading ASX 200 CFDs as they are typically based on the SPI’s movement.

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. Also, while I am happy with the premise that large ASX stocks and the SPI 200 will most often open lower or higher due to overseas movements, a filter could be applied to remove announcements/ news for individual stocks or region specific news.

Potential improvements aside, to me 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