This research paper had an interesting look into gaps down in stocks (www.mta.org/eweb/docs/pdfs/2011-dowaward.pdf, thanks to Richard for making me aware of this report). I recommend reading it. I have no knowledge of the people who has made it, but I tried to some twists in the same direction myself.
I made my own strategy more or less based on the same criterias:
- The stock must gap down. That means todays HIGH must be lower than yesterdays LOW, and
- Todays volume must be lower than the average over the last 50 days. This is important. A higher volume most probably means bad news and will likely lead to more selloff.
- If all the above mentioned criteria are met, entry is on the next day if the stock falls 0.5 times Average True Range the last 50 days from the open.The reason I want to buy if the stocks falls the next day, is that this strategy has no edge over the first 1-4 trading days. Actually, I have a potential twist to this strategy of going short. I’ll publish that later.
- The stocks closes above the 10 day moving average, then exit at CLOSE, or
- The stock reaches a target of 7.5%. It’s better with a higher target, but a lower target locks in profits on “dead cat bounces” during bear markets. If target is reached, the target price is exit (but if the stock gaps up higher than target, the OPEN is exit).
- If neither 1 nor 2 are met, there is a timestop of 15 trading days at the CLOSE. The reason I have chosen 15 days is that stocks have performed well over this period. For a shorter period it is much more erratic. In general, stocks fall a lot faster than it rises.
My sample is on the S&P 600 stocks that were in the index in January 2007. That means there should be less survivorship bias.
Here is the result with 5000 USD per position:
Here is the equity curve with max 10 positions (on days with more fills positions are picked randomly) and NOT reinvested profits:
Annual returns is about 11%. 2804 trades in total, ie. a lot of potential trades are not taken.
Now, this strategy can also be traded with an entry on OPEN, ie. go long on the open in point 3 on the entry criterias and not waiting for a drop from the open. The results are still very good with an annual return of 12% (higher return because of a lot more fills).
Do any readers have any inputs/suggestions?