S&P 500 has historically a strong tendency to revert to the mean. I’m looking to find a way to fade the gap. My research has indicated that fading the gap is best after a strong move to either direction. Here are the criterias for a reasonable solid fade the gap strategy:
- Calculate a 25 day average of the (High minus Low). That is the “ATR”.
- Calculate the Low of the last 10 days.
- Calculate the (C-L)/(H-L) ratio every day (IBS).
- Calculate a band 2.5 times above the 10 day low using the average from point number 1 (ATR).
- If SPY closes above the band in number 4, and point 3 has a higher value than 0.85, there might be fade the gap trade tomorrow (short side).
- If SPY opens up more than 0.1% the next day, go short at the open and hold until close.
Reverse all this for long trades, except for point 5: There are significantly fewer trades on the long side, and this number can be set to 0.25.
There is no target or stop-loss. Using a target just set a stop in the profits.
Now, this might have been better formulated. I hope the readers understand the strategy.
Here are the numbers from 2005 until October 2012:
As you can see from the numbers the win ratio is not fantastic. I have fade the gap strategies that have a much better win-ratio. But the best part is that this simple strategy has a high number of very big winners. And I’m using only open and close so it should not be any big errors in the quotes (from Yahoo!finance). I have traded a twist to this strategy before with success, but this one looks better. The bigger the gap, the better it works. And the more volatile move before, the better, so this can probably be improved.
And the equity curve (blue line is long and pink line is short):
This works reasonably well. There are big winners and the losers are quite moderate. Even removing the big winners the average is quite good. The good thing is that short is actually better than long, something which is rare.
This strategy does not work holding overnight.