EminiForecaster's blog

[EminiForecaster]

Labor Day Week and Finding Seasonal Cycles Around Stock Market Holidays

Much of the work we do is based around analyzing cycles in the market. There are various ways to do this. Fourier transforms, trigonometric regression, Hurst channels and pivot projections to name a few. Cycles in the stock market can also come under different names, such as “seasonal”, or “seasonal trading”. A seasonal is just another form of a cycle, but seasonal are date dependent functions and cycles are often date independent.

There are cycles on all different time frames. For example, if I make a composite of the market over any different unit of time, it may reveal to me various seasonal tendencies during that interval that have occurred in the past. Many of the most successful traders in the world use this kind of method.

To make a composite on an annual basis for example, we would start on Jan 1st (or the first trading day of the year) and, in the simplest scheme, sum all the various years together into one value for each calendar day of the year. For the last 20 years, it would look something like a low of the year at or around October 17th and a high of the year at or around Jun 17th. This seasonal tendency can actually be detected (plus or minus) going back as far as we have data on the stock market.

Armed with this information, one could buy October 17th and sell (or sell short) June 17th each year. Historically, this would have been very profitable.

Some years this seasonal does better than others. I have developed some amazing trading systems off this one basic principle. For many people though, trading off this cycle is just too long term. In the years you are wrong, it can hurt. Some form of risk management is required to make it more palatable. One way to do this is to trade off a weekly time frame in order to manage risk a bit better. That gives us approximately 52 segments in a year in which we manage our risk.

There are other amazing seasonals that occur in a shorter intervals that match this weekly time frame. One such cycle is holiday seasonals. We are approaching the Labor Day holiday this coming weekend. Let’s take a look.

Here is a chart showing last year’s price action (the candle stick chart) with the current price action mapped on to it going into the holiday (green line).

This weekly analysis is mapping on to the historical past with remarkable accuracy.

This type of analysis is consistent with one of the many cycle analysis methods mentioned above and is also consistent with some of the techniques we use at EminiForecaster.com to generate our accurate weekly forecasts.

Just how accurate is it to pick a weekly low with such accuracy? There are approximately 40, 10 minute bars in a day and just over 200, 10 minute bars in a week. Picking a low within 200 minutes, or 20 bars then is an accuracy of about 90%.

When the seasonal is following as it was earlier in the week, it confirms the seasonal is in effect. We can run various correlation studies to deal with this problem mathematically that feed the correlation back into the input of the computer model that successively approximates which seasonal (or cycle) we choose to trade.

To read more posts like this - EMF Blog

 

[TomTom]

I agree with your comments, this week we need to break out to the upside from 1300 SPX on that beak out I will have buy stop orders to enter long till 1307 until i re-evaluate the position.

May be we see this happening from tues to wednesday ?

We shall soon see

 

[EminiForecaster]

indeed we did breakout

 

[EminiForecaster]

10 Things You Should Do While the Market is Closed on Labor Day

1. Get caught up on your unanswered email
2. Update your To-Do list, goals
3. Call people you haven't spoken in a while
4. Visit gym for god's sake!
5. Write a trading plan for Tuesday and the following week
6. Finish reading that book that's been laying by your bedside
7. Go outside, get some fresh air
8. Analyze your account equity and find ways to improve your trading
9. Get social - traders tend to be isolated/antisocial. Join online social networks like twitter, myspace, youtube, facebook, trade2win.
10. Spend time with your family members!

From EminiForecaster.com we wish you a happy Labor Day!

 

[EminiForecaster]

Indicators Debate Solved Once and For All?

The truth is out. The traditional argument as to whether technical analysis has any legitimacy as compared with traditional buy and hold stock market investing techniques lives on and the few of us as money managers who seem to have survived, smile knowing much of the argument is amiss in what it is really asking.

I have managed to survive and do well as a money manager. I have watched market advisory services come and go over the years with new ones coming forward with new claims and new participants entering the market ready to eat it all up (or be eaten).

But, what is it that has enabled me to survive as an active manager? Is it my phenomenal skills? Is it this magic thing called “Technical Analysis.”? Or is it just simply being in the right place at the right time?

Certainly two of three of those choices could be random. But one thing is not, and that is Technical Analysis. In the traditional sense, as one might read in books, I have never ever found any technical analysis tool to be of any benefit to me in the development of a trading strategy (barring moving averages which I use to introduce intentional delays or to create zones to trade from).

So if I could never use them, then what exactly is it that perpetuates the myth (at least as I see it)? The best guess I can come up with is failure to do a simple test of the obvious. The survivorship bias of most people not staying in the game for any length of time results in new participants going back over the same nonsensical stuff again and again.

So, I decided to conduct a test (actually, I did this 15 years ago but will duplicate it here for you). Real science (as I have done for years) and resolve, once and for all (or at least in portion) this debate.

I conducted a test on the efficacy of stochastics (oscillators in general) as stand alone trading devices. The text book method for the use of these tools in trading is that a condition below 20 means the market is “over-sold” and should be bought. If the oscillator goes over 80, it is then called “overbought”, and should be sold.

This all seems very scientific. And, if you look at a chart, your human eye will gladly pick out all the highs and lows the oscillator picked (to the exclusion of all else). Convincing! But as I said, this is science, so we won’t rely on the human eye.

Oh yes, you might argue. Stochastics (oscillators in general) can be used in other ways than for overbought or oversold conditions. I full heatedly agree. But the principle in the following tests will still stand. So, bear with me…

Let’s look at a scatter plot of a stochastic oscillator for various levels five units of time into the future. This picture will tell us everything we need to know about stochastics (on the given time frame) without any messing around (this is what scientists do) -

The graph is made up of over 3000 data points on a 5 minute chart, looking 25 minutes into the future. Now before your brain shuts off, don’t worry. It is not that scary. Simply, it shows us that on this particular test, for values of the stochastic oscillator above 80 (that is supposed to be a sell signal) the returns vary from -10 to +10 points overall. In fact, the returns vary from about -10 points to +10 points overall. Over on the left, it does show there were about 5 events (grey dots) where there were declines of as much as 20 points, but over all, the graph is random (evenly distributed). On the bottom of the graph, we can see, below 20 (that is supposed to be a buy signal), the returns are also distributed from about -10 to +10 points. The middle ranges are also similar. This tells us that the distribution of prices 25 minutes into the future on a stochastic oscillator are… (oh no Rob, don’t say it) RANDOM!

There, I said it. Random!

If you had traded using the 80/20 rule over the period of this test, holding 25 minutes on each trade, you would have lost over $3000 not including commissions. Next time you think about using an oscillator in the textbook traditional sense, remember this.

The fact is, this test result will hold true for just about any time frame on oscillators and just about any other technical analysis indicator. As the time frame increases, it may become more reliable (at least on stock indexes). In many other cases and markets will actually be the opposite (ie. Buy 80 and sell 20).

Maybe the age old debate will linger on? Maybe I have put it to rest? I think not. Though I am sure I will get some responses to this (and I hope I do) so you can send me your technical indicator. I will gladly test it for you and send you the scatter plot with an interpretation (subject to my own scheduling). Fact is, I have never seen a technical analysis indicator hold up to this type of scrutiny and this is one of my “nice” tests ;-)

This article is not to discourage the use of oscillators or other technical analysis tools. Quite the contrary. Tools do have their places depending on the intent and design. I always encourage trading based on a solid premise. Getting at the testing of the premise is key, and scatter plots is one great way to cut through a lot of garbage and find truth quickly and save you from a lot of heartache. It only took a couple minutes to set up this test. I encourage you to do the same, or, send your indicator or trading system to me and I will test it for you and help you with logic and improvements if I am able…

When you find a solid premise to work on that holds up to stringent testing, you can start making some good money trading with it. Knowing where you are through testing makes the psychological component of trading easier, lending to the mental success cycle required to succeed financially. Asking the right questions can put debates to rest and lead you to greener pastures.

For more info go to http://eminiforecaster.com/blog

 

[EminiForecaster]

The Benefits of Trading One Market Over Another

It always amazes me how people do not understand the financial implications of their trading activities. It is hard enough to be profitable, let alone having to deal with the IRS and trading expenses. Knowing the various issues involved can help you to make significant differences in your bottom line.

Many people trade in and out of the market, not realizing the implications of trading expenses. One such expense is commission. Commissions are quite different on stocks and futures ( Yes, many people say futures are risky, but that is not because of futures, it is because of the people who trade them and how they do it).

An Emini S&P contract, which is traded on the Chicago Mercantile Exchange out of Chicago, represents $50 times the index in value of the S&P 500 index. If the index is trading at 1300 then, it is $65,000 worth of stock. A small account can trade in and out of this market for only about $2.40 per side all expenses included ("all in").

On the flip side, you can trade the Spyders, symbol SPY. SPY is an Exchange Traded Fund or "ETF." ETFs are a fast growing market place and are attracting huge amounts of capital, as are the Emini S&Ps. SPY would trade at or about $130 per share when the S&Ps were trading at 1300, so an equivalent purchase would be 500 shares ($500 * $130 = $65,000). At a decent broker, you could trade that at around a penny a share, or $5.00 per side, almost twice as much as the Emini contracts.

Then there is the topic of slippage because you always pay the ask to buy and the bid to sell. This is another hidden expense that, if you are trading frequently, will add up to a lot in time. On the SPY this "spread" is typically a penny. At $130, this is another $5.00 per side, making a total of $10 per side on the SPY to get in.

For lower priced stocks, such as the Nasdaq ETF (QQQQ) the expense is substantially more on a percentage basis, because it trades at a much lower price (therefore you are trading more shares). Most ETFs are lower priced that the SPY, making the SPY an excellent choice as a stock market based trading vehicle.

On the Emini S&Ps the minimum tick and expected slippage for a small account is $12.50. Add the commission to that of $2.40 and you are at around $15.00 each side. Substantially more than the SPY, but less than many other ETFs on the stock market side.

Then comes the taxation portion of the equation. Of course you will want to check with your accountant on this, but stocks, or ETFs are taxed as short term capital gains. Futures are taxed a partially long term capital gains (60%) and partially short term (40%). As a result, the tax benefits of using futures as an investment vehicle for actively traded taxable accounts can be substantial.

One other factor influences my personal decision to trade futures over ETFs on my stock index trading and that is the nightmare of dealing with stock brokerage statements and my accountant. If you trade actively, you will pay your accountant a lot to sort through all crazy ways your stock brokerage puts together statements making it difficult to reconstruct what happened for accounting. To make it worse, when you call the brokerage for assistance, they can't seem to tell you what the statements mean either (I speak from experience- try it for yourself).

Deciding which vehicles to trade when you are an active trader can be a very important decision, hopefully this will help you as a guide to structure your trading activities to best benefit. My choice stands with futures.

Visit my blog here

 

[EminiForecaster]

How to Manage Trade Risk to Get Into the Big Winners

One of the most important things about trading is the management of the risk on your trade positions. Let’s face it, if the market just doesn’t go anywhere while you are in a position, you just cannot gain from it. So, depending on market volatility, you really cannot control to any degree what your gains will be. You can, however manage what your losses can be to some degree with good risk management techniques.

The principle is simple but it is really hard to do (all these examples will be based on a long trade, use the opposite for shorts). When entering a trade, I simply do the opposite of what I feel. That’s right, buy when the market is falling and sell, when it is rising. If trading on a daily time frame, to buy for example, I might like to see the market at a 3-5 day low, or below a moving average of some reasonable length. Then, I like the particular interval I am in to also be down. For example, I will buy on a down day.

I have attended money manager conferences and listened to industry professionals talk about how they will buy into strength. This is great in a bull market, but in today’s uncertain markets, in my opinion, it is a recipe for disaster.

Let’s look at the logic of it. That stock market spends a good portion of its time alternating up and down without making any ground. This is true on just about any time frame. Research suggests this is true around 66% of the time. That means you have a significant edge over random entry using this concept for trade entry alone. Further, it tells us that as the market moves higher (on a buy) there is that much less to go before it turns around and continues back down again. As a result, it can be much lower risk to actually enter a buy when the market is declining (to some measure of its alternating range) because the amount I stand to lose is lessened.

So, even though it is very uncomfortable to buy while the market is declining, I know it is reducing the amount of risk I will take on the trade at the same time.

Let’s consider the psychological factors as well. If I am feeling really scared that the market is falling when I am putting on a long trade, I know most other market participants are feeling the same thing. This assures me that my fear to buy is really an indicator that measures current market sentiment. If sentiment is really that low, then I reason we must be running out of sellers to drive the market lower.

Let’s look at it from a numerical standpoint on where I might place a stop loss order. If the recent previous low on the S&P is at 1280 and the market is declining into that area, I am thinking the market will likely react and go back up at that level. If I buy near that level, I can place a stop beneath it by a reasonable margin, say 1275 and have that be a reasonable measure, if it gets hit, as to whether I was really wrong or not. So as the market declines to that level, my mind is oscillating between the greed of buying the absolute low and the fear of it continuing to fall. But, for every point it falls, it is one more point reduced from my risk. At some point in this equation and mental oscillation, I pull the trigger and buy (preferably at 1280 or so, if I can get it).

Using this mental exercise to enter a trade has taught me much. I have done this for years and have been very successful with it. Now, having trained myself in this way, I experience fear if these conditions are not true. This is true because I want to get a good deal, and this translates into small stop sizes and smaller losses when I have them.

What does this mean in the big picture? By keeping my losses reasonably small and going against the majority, I do not get demoralized by trading. That keeps me in good spirits while the market is beating people up (which is just about the time it will take off for a really good move). So the famous wisdom of Rudyard Kipling stands; it is important to keep your head about you when all about you are losing theirs….

You can’t win if you don’t play the game. The market has a way of demoralizing its participants just before the very best moves. By keeping your risk managed, and your spirits high while trading, you will always be there when the market decides to deliver you a really big trade (the one thing you cannot control). Make sure you are there to benefit from the spoils of the trading battle.


Rob Mitchell is co-owner, researcher and head trader at EminiForecaster.com, a website specializing in cyclical stock index swing trading. For more articles like this visit my blog.

 

[EminiForecaster]

How I Made 90 S&P500 Points In One Day

September 16th, 2008. I don't like to brag but lately too many traders have been getting hurt in the markets and I think it is unfortunate. Today for instance was one of the most volatile days I can remember - AIG opened below $2, a day after a 4% sell off, FED meeting, bankruptcies, well, you know the rest of the story.

As you know I trade all over the place, without stops, indicators or other clutter.

My only tools that are available to everyone are EminiForecaster.com G-lines and MarketDayTreaders.com G-signals - that's it.

Having said that, today, I was able to outperform myself! When volatility kicks in I reduce the number of contracts I trade, sometimes down to only 1. This is good because I know I will get all the benefits (and risks) of a volatile day like today. Just look at today's 5 minute chart and calculate an average bars' range, some 20 months ago that was the range of an entire week!

Anyway I traded like a maniac trying to beat the signals using my intuition and experience. And here are the results:

- 10 round trip trades

- $4,500 or 90 ES points

- quit trading for the day at 3pm EST

- made about 33% on that particular account

Here is how G-Signals from MarketDayTraders.com performed today (with a 5 point stop) -

click here for more history charts

Not bad, as you can see I took advantage of some of the trades that were recommended -

To learn more about G-Signals go here http://MarketDayTraders.com

- Vadim

Images are copyrighted by TradeStation (TM)

Rob Mitchell is co-owner, researcher and head trader at EminiForecaster.com, a website specializing in cyclical stock index swing trading. For more articles like this visit my blog.

 

[EminiForecaster]

Stock Market Overbought or Oversold? Don’t Kid Yourself!

I have heard people refer to the market being “overbought” or “oversold” for as long as I have been a student of the markets. To be sure, only one of the two terms has any credibility and that is oversold. There is one case for this, and that is when the market is trading at zero. That is oversold! It is the only real case. Since the market (S&P 500) is trading at 1250 as I write this, I guess that isn’t likely to occur today (or at any time in the near future for that matter).

Unfortunately, for those who wish to use the term “overbought”, it is important to note that the market has unlimited upside potential. So this case can never really occur. So there is no such thing as overbought at all.

I suppose people mean some kind of relative term when they speak in this way. In this manner, “overbought” translates to the market is high (higher than it was before). “Oversold” would translate to mean it is lower than it was before. Since the market alternates in a range a huge percentage of the time, one would conclude that such terms are even more un- meaningful than would otherwise have been the case.

Let’s look at it from the other side of the coin. For 1990-2000 the market remained overbought for a period of about ten years. I suppose there were occurrences within the minutia that could have been relatively higher or lower compared to the past, but what is the use of a term that draws your attention to the obvious.

That’s why I decided to coin a couple new terms, to put a new perspective on the whole thing. This is really quite exciting. A revolutionary new concept. My new terms (and feel free to use them widely to get the buzz going) are “Underbought” and “Undersold”.

Yes, I know, undersold is already in use. Well, not in this proprietary sense in which I intend its important new meaning. You see, “undersold” is the opposite of “underbought.”

So what is this “Underbought?” Quite simply, it is when the market has not raised enough to be where it will be in the future. This means “undersold” occurs when the market has not declined enough to be where it will be at in the future. So these important key terms carry a whole different kind of meaning to their (rather meaningless) counterparts “overbought” and “oversold.”

You see, “overbought” and “oversold” look at the past to decide where you are now. But underbought and undersold, look to the future to tell you where you ought to be. This is a huge difference! This is especially true since it is only the future price (with respect to where we are now, or have entered the market) that has any meaningful value to us at all!

I want to start a movement of future looking market participants that don’t dwell on the past. Let’s get over it and move on. The fact is the most successful investors in the world are forward looking market participants. They trade developing trends in the markets. They are anticipatory investors.

This means that most people who are not successful in the markets spend their time oriented to the past. Conducting “backtests” of data to see how the future will be. Ouch.

So I vow today to never say “overbought” or “oversold” again and give myself to the infinite future that stands before me. Its “underbought” and “undersold” from here on out baby!

Please join me in the revolution to make these important new trading terms a solid reality!

Rob Mitchell is co-owner, researcher and head trader at EminiForecaster.com, a website specializing in cyclical stock index swing trading. For more articles like this visit my blog.

 

[EminiForecaster]

Finding Cycles in the Stock Market Using Ancient Techniques

Much has been written about various cycles in the stock market, other commodities and investments.

One very famous example is the Delta Phenomenon, a trading book that sold huge quantities at $175 per copy (and some for many many times that). The basic idea has to do with lunar cycles.

Lunar cycles? Stock market? About now, I can hear you saying, “what a bunch of #^$%.”, but bear with me because, if you are of the hard core left brained approach to such things, I would like to point out that even the Atlanta Federal Reserve has published a white paper on the geomagnetic influences on stock market cycles (http://www.frbatlanta.org/invoke.cfm?objectid=AFD46B63-2852-4812-BE83E6D0C777F4BF&method=display).

I have done a tremendous amount of research in this area, devoting several years of my life to this very topic. Much new research in astrophysics is revealing we really live in a very electric universe (http://www.thunderbolts.info/home.htm). I have been able to achieve winning percentages in the 90% range on longer time frames using geomagnetic data to time the stock market. So, don’t knock it til you try it ;-)

Modern world culture has largely abandoned the use of what our forefathers commonly used, and that is the lunar calendar. Many ancient cultures, such as the Chinese or those of the Jewish faith, for example, still retain this tradition. Many Buddhist traditions carry certain days of the lunar month as having certain significance. This is also true in Indian writings such as the Vedas.

Is there some wisdom to counting out events according to lunar cycles instead of only solar ones as we do here in the west? Does reliance on a purely solar calendar hide things from us that would otherwise be obvious on another interval? I certainly think it does. After all, the moon, for example, surely influences fluid flow, and we are largely made, of water. The moon and sun also significantly influence charges on the ionosphere that impact our environment. So, these things all tie together. As mentioned, physics is now coming to find more detailed reasons to believe electromagnetism and gravity are really opposite sides of the same coin. For more on this, you might enjoy the articles of Myles Mathis at http://www.milesmathis.com/

There are many physical cycles we could analyze that influence human behavior as it relates to the stock market. As an exercise, let’s see if we can find any truth to stock market cycles that are based around the lunar month (from new moon to new moon). There are many such cycles we could analyze, but this one will suffice to show some interesting cycles and, how one might go about discovering them. Then, you can write me to tell me what you have found;-)

To start with, in trying to find the data to do these tests, I quickly found there was no commercially available software that could export any reasonable amount of data. So I developed my own. I call it the “Astro Data Generator.” It will generate any data you need for just about any planetary body in the solar system (ie. Declination , longitude, speed and distance etc.).

The new moon is simply an event that occurs when the sun and the moon rise at the same time. So I export data for the sun and moon and use my spreadsheet to identify when they cross. Then, from that point, I will count forward, buying and selling the S&P 500 (the best example of the tradable US stock market as a whole) at each point (daily) in the cycle. Here is what I found:

As can be seen in the above table, there is an excellent bias around purchasing the 23rd or 24th day of the lunar month and holding into the 4th day of the lunar month. We can also see a bias as follows:

5th-14th short, 15-17 long and 18-21 short.

As you can see, there are clearly cycles present here. In fact, this particular end of month buying and carrying over into the new month bias is well known on a calendar basis. However, I have never seen a study done identifying an end of lunar month pattern like we have done here. It is a unique study. It is often reasoned that this solar calendar effect is due to “window dressing” by fund managers to make their portfolios look better. Seeing this lunar bias makes me wonder whether it is in fact something altogether different. To get to the bottom of it would require more research that is beyond the scope of this article.

This is certainly not trading advice at this point. For example, to turn this into a tradable pattern, I would do some statistical analysis to see the distribution of trades. Either way, it tells us that much more about human behavioral (stock market) cycles that, could themselves be driven by external forces that are cyclical themselves.

Research in the area of stock market cycles that are driven by other external phenomena is a very fruitful area of research that can lead to substantial benefit. Hopefully the future will bring more thoughtful minds into this arena.

Rob Mitchell is co-owner, researcher and head trader at EminiForecaster.com, a website specializing in cyclical stock index swing trading. For more articles like this visit my blog.

 

[EminiForecaster]

Debunking the Price Gap Myth - And how gaps influence your trading

A morning gap occurs whenever there is a difference in price between the previous day’s close and the open in the morning. Theoretically, there are really two of these types of conditions that occur. A true gap is where the open is above or below the previous day’s high or low respectively. On a daily chart (chart provided compliments of TradeStation) this would leave a hole in the chart as in the image below.

As you can see in the graphic, the high of the third bar and the low of the fourth have a gap which is marked out by the horizontal lines.

Another case, that I believe was coined by Larry Williams, is where the open is above or below the previous day’s close but the price is not above or below the previous day’s high or low. He called this a lapse, so we will use that term. On an intraday chart, a lapse looks like this.

On the lapse chart we can see the market opened down, but not below the previous day’s low (as indicated by the horizontal line).

The difference between a gap and a lapse is important. A gap is a different type of event than a lapse. A gap takes much more risk for traders to take price outside the previous day’s range. As a result, gaps are often driven by more powerful forces than lapses.

It is commonly said, as a rule, gaps, and lapses, get covered. What this means is, at some point, the market will go back over that area and fill it. Conventional wisdom says, more often than not, a small gap or lapse will be filled in relatively short order. Further, the conventional viewpoint says on the day, and often the very morning it occurs, a gap or lapse will tend to be filled. It is also maintained by the majority of traders out there that Gaps or lapses of large magnitude can “run” away and not be covered in the near term.

Some traders specialize in this area alone and only trade morning gaps and lapses. If they are to be successful at what they do, then the truth about gaps and lapses in general must be known. Let’s take a look (over the last two year period) and see if we can get to the bottom of this.

The graphic below shows the equity curve of a simple trading system using one Emini S&P contract. It buys down gaps and sells up gaps without regard to the magnitude of the gap. On an up gap, it will exit the short position if the gap closes to within the highest of the previous 5 (5 minute) bars from the previous day. If it fails to achieve this at any point during the day, it exits on the close. Similarly, for the down gap, it will exit the long position if the gap closes to within the lowest of the previous 5 (5 minute) bars from the previous day. If it fails to achieve this at any point during the day, it exits on the close.

As you can see from the graph, there were just over 90 occurrences in the last couple years of true gaps. The result of trading these according to conventional wisdom resulted in a loss. Over all, this system was 48% profitable. There were periods where doing the opposite could have been very profitable and periods where conventional wisdom held. As a general rule, for gaps then, we have a pretty much random result.

Let’s look at the case for Lapse conditions. The rules are the same as noted above for gaps. Trades are only allowed at or before 935AM Eastern time.

We can see there were about 140 cases of lapses in about the last two years. The result of trading according to conventional wisdom would have taken us on a wild ride indeed. During the period covering somewhere about the first year, it would have lost around $8000, and during the most recent year it would have made around $5,000. This would only be true if you had been smart enough to switch strategies at exactly the right time. Not a very likely sequence of events. This test also came up at about 48% accurate, again showing this approach to be more or less random.

What if we were to parse out the gaps according to certain magnitudes and trading only the smaller gaps or lapses?

As can be seen from the above optimization grid (compliments of TradeStation), the test for only trading smaller gaps did not pan out. Some were profitable and some were not, with only 3 out of 19 tests being profitable. This again confirms, over the last two years, gaps are more likely to run than cover. Are bigger gaps more likely to run than smaller ones? The data suggests a gap greater than 9 points may be more likely to run than gaps less than 9 points, however, the distribution of returns above that point does not increase with increased gap size. Therefore, this conventional wisdom is only partially true, if at all.

Does this article claim the trading of gaps to be of no value? Absolutely not. The trading of gaps can certainly be viable if managed correctly. For example, our lapse equity curve shows a very strong linear relationship at various times. To improve upon this, one might research switching from one method to another under changing equity, or in any number of other ways. One example that could be extracted is the case for trading gaps that are more than about ½% as runaway gaps.

With a little creative thought and a couple simple research techniques such as those shown above, one could find plenty of trading opportunity in this exciting area of gap/lapse trading.

If you are a swing trader, it is of paramount importance you understand how gaps and lapses impact your trading. Typically this will impact you on entries and on overnight moves. If you are entering short, one of the best things that can happen to you is for the market to gap, or lapse up. The worst of course, is to enter short on a down gap/lapse. Because selling at a lower level increases risk on your position.

If you are already in a position, say long, and the market has a smaller magnitude gap or lapse against you, it is less likely an actionable event when compared to a case where you have a large magnitude gap going against you.

It is extremely important not to simply take conventional wisdom and act on it without first evaluating the turf on which you play. Doing so can cost you and can result in a disastrous trading record. Always research your method thoroughly before risking hard earned dollars, or enlist the help of a professional to achieve this goal.

Rob Mitchell is co-owner, researcher and head trader at EminiForecaster.com, a website specializing in cyclical stock index swing trading. For more articles like this visit my blog.