Should a large SPY gap-up be faded or bought?
On April 20th (or 3 days ago at the time of the writing of this article), SPY gapped-up over 1%. Not only was the gap-up large, but the low for the day was less than a dime beneath the opening price.
Gaps can be measured a couple of different ways, and for these tests, I’ve measured them from the previous close to the open and from the previous close to the low of the day. For example, SPY could have an opening gap (measured from the previous day’s close to the open) of greater than 1%, while the gap measured from the previous close to the day’s low would be less than the amount of the opening gap. Measuring the gap from the previous close to the low will be more restrictive and result in fewer trades.
Buy SPY at the close if
- The distance from the previous close to the open is greater than 1%
- The distance from the previous close to the low of the day is greater than 1%
- Sell X days later
- No commissions or slippage included
- All SPY history used
Summary of Results:
The blue line measures the gap from the previous close to the low, while the red line measures from the previous close to the open. Remember that there are many more gaps that are greater than 1% from the previous close to the open (179) compared to using the low (57).
The green line is a very simple measure of buying and holding SPY over X number of days, starting with the first day of SPY history. This measure is limited, to be sure (for example, altering the first day of data by a month or so will affect returns), but it does give a baseline from which to compare the gap trades.
Compared to the baseline, after a large gap up, SPY under-performs. However, the average trade low over the next 20 days (for both measures of gaps) is greater than the gap amount of 1%. This suggests that a gap-fill may occur intra-day, but on a closing basis, we are better off NOT betting on a gap fill over the next 20 trading days. Put more simply, large gap-ups are not easily filled.
After 13 trading days, buying after a large gap-up has tended to out-perform the baseline SPY performance.
Bottom Line: Fading large gaps with the hopes of profiting from a gap fill may not be the best way to play. Instead, it may be better not to fade, and instead buy weakness after the gap-up.