Gap trading strategy: Backtest and key factors for successful implementation

Calculation link …

In this post, I will describe the main idea of quantitative trading and will demonstrate how it works using GAP trading model and appropriate timing tools. The modern trading algorithm based on a robust and sophisticated set of orders that reflect different execution styles and described in the post. In addition, you will be able to read about 3 major working rules for a Hedge fund. 1. Algorithm seeking to trade (set of rules and its backtest). 2. Volatility timing and 3. Implementation or received benefits from mitigated volatility to use leverage trading to boost strategy CAGR.

There are two major types of investments (portfolio investment and direct investment) Also third, that appeared for the last 20 years  – quantitative investment. There are plenty of quantitative models to invest money and as an instance it are – pair trading, momentum trading, arbitrage, contango monetization, GAP trading. Quant means that all these trading ideas prior to being applied to the trading process has to be matched or interconnected with a set of rules that will lead to the ability to measure the expected result. It is a system where trader starts to trade just following to trading “road map” that measuring outcomes based on different assumptions. Sounds difficult and I will explain using GAP trading set of rules

1) Time (last second of market close or every 5 sec prior to market close open long position.

2) Side of trade – BUY

3) Instrument– SPY (SPX500 etf).

4) Type of order market on close (MOC). Trade frequency – everyday as stock market venue open. This is a set of market in rules.

The market out rules. 1) Close open position on first available price (market print) to make position equal to zero(Market on open order).  2) Maturity of Position maintenance – overnight (it is idea of GAP trading).

GAP strategy trading backtest and its result vs SPY buy and hold (cost of transaction not included)

GAP strategy and SPY buy and hold drawdown comparison. DD modification and its calibration using different leverage ratios.

As you may note – to be on the market using GAP strategy has almost the same results as SPY passive investment since 1993 to the current time. I use a simplified way to make a judgment about strategy efficiency using Drawdown (DD) comparison as key criteria. For deeper assessments, make a sense additionally to use Soriano and Calmar ratios.

DD comparison shows that GAP strategy results much better from DD perspectives and it creates room to apply leverage. This is a key element of leverage based trading in quantitative investments that use the principle of equivalency.

What does it mean? Investor ready to accept the risk of investments in SPY. It is a crucial idea that works for Buy and Hold and GAP strategy because in both cases only one instrument is tradable – SPY. It is equivalent risk – do I owning SPY with buy and hold or GAP strategy x 1,6. Conclusion. Best ever way for trading – to mitigate volatility as much as you can and trade it using leverage. In all other cases, the advantages of Leverage is gambling and it will be better to stay away from it.

GAP strategy with boosted return from using of leverage 1.6x

Trading metrics summary and results

As you may see 1.6x Leveraged trading of Gap strategy in 4 times better then SPY buy and hold with almost the same DD metrics. Hence, the Hedge fund with a goal to trade GAP and overrun the passive investments return can be launched. Positive alpha created CAGR of GAP strategy 13.47% vs 7.42% of SPX buy and hold. That is a great result +6% to CAGR with the same risk metrics.

Issues. Probably now after reading what I wrote about GAP strategy, you can decide “Oh great I will start from today to trade it”. All not so simple. Wall Street never gives free advice and do not creates an opportunity for everybody. This GAP trading part of the big model of market making. Etoro as instance and all other retail brokers have a huge commission for round trip trade on a daily basis. Also, retail brokers very rarely give the ability to execute a transaction using MOC or MOO orders, market imbalances and dark pools that distribute liquidity among major players.

Solution. Sound simple – take DMA (direct market access) using the proprietary firm for trading. Use stocks for lending it overnight and receive % and dividends. It is an institutional approach that why quantitative trading is acting like casino owner and will never lose.

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