In the prior post about the GAP strategies implementation as quantitative investments, we explored earlier SPY ETF (SPX500) as main instrument for GAP trading. Prior post caused high interest to this topic and I decided to extend this research and explain this phenomenon. From mathematical point of view, we can detect that Sum of GAPs gives result of investment growth that will exceed passive “buy and hold” return. This is not coincidence, I will try to explicit what source of it, and why the GAP works better than “Buy and Hold». In addition, GAP strategy less volatile vs “Buy and hold” that creates potential for leverage implementation.
Firstly, I would like to emphasize that it is impossible to trade GAP systematically using retail brokers due to high commission and spread that will consume a profit from transactions (details about trading mechanic introduced here link) . Despite on that you can utilize the research result as evidence that in common case to stand on the long side for GAP time make a sense and it will let you to exploit positive math expectation of GAP outcomes.
Earlier we looked at SPY with annotation to trading process. Now I will take the same “market in and market out” rules that described in prior article and result will be the same and even better for QQQ (NASDAQ). Amazing – GAP trading again shows that amount of positive outcomes exceeding negative and total return for GAP strategy for QQQ looks again much better than “Buy and Hold”.
Calculation link is here https://docs.google.com/spreadsheets/d/1eVsqq7GGdODDULcpR_WZV4rtzXsPSdepxw8Hkq6PIZs/edit?usp=sharing …
As you may see from plotted above chart GAP strategy that based on QQQ as trading instrument was able to overrun passive investment almost in 3 times. Stress test and max Drawdowns shows that Gap strategy has a room for leverage application (in detailed how to define leverage size using rule of equivalency explained here). As result obtained CAGR with same level of risk is 29.38% vs 6.74% buy and hold QQQ. Positive alpha is 22.64%
Now as we know the efficiency of GAP trading it make sense to look at conditions that make it real. Why does it work and positive GAPs have so clear appearance and sustainable for long time in different market regime, either it in bearish or bullish trajectory. I would like to point out 3 main reasons that have a lot of common with psychology and trading process.
1. Psychology – it usually need a night to overcome bad news and sentiments. Humankind naturally inclined to be optimistic and proactive way of thinking is dominated behavioral model. That works and for stock market with positive GAP.
2. Orders setting timing is second main reason. Stock market biased to growth and crowd always rush as quickly as it possible to join the trend and brokers accept buy orders to open position from around the word and sum up it for next working day placing it as all in order on market open price. The adjust trade imbalances pushing price higher.
3. Amateurs trade by first open price and during first half of hour since trade session starts, but professionals operate during trade market open hours allocating liquidity for all working hours of main session.
Further, I will continue to calculate GAP trading models using other instrument and tools with more sophisticated conditions for trading. In addition, I will show how it works for EU indexes and what is practical obstacles to trade GAP in France, UK or German Indexes.
The purpose of this information was in most simple form to give you details about quantitative and algorithmic trading using very familiar to trader’s event that is GAP. Please follow www.vessel-capital.org for more details and tips.