## Blog / GAP Retracement Study

### GAP Retracement Study

In investments and in trading risk is very important aspects of our market participation.

Overnight traders, swing traders and investors must accept the overnight risks, that the market poses.

One aspects of the overnight risks is the GAPS, that the market presents at the regular market open in those instruments, not traded 24 hours a day.

Day traders also impacted when formulating their market participation strategies depending upon the GAP at the market open.

To help formulating those strategies we would like to know what happens after those GAPs.

For us the pointers in many cases are in the form of probabilities, so we created some studies to find out what can we expect after a GAP.

First to define a GAP, we present the following image, which consists of two candles:

The GAP is between the Close of the first candle and the open of the second candle.

The GAP percentage can be calculated as follows:

GAP [%] = ABS((C2.Open – C1.Close) / C1.Close * 100) [%]

The actual GAP is a GAP Up, if C2.Open is greater than C1.Close, or a GAP Down if the C2.Open is below C1.Close.

One important aspects that we would like to know, is related to the retracement of the GAP during the market day.

We say that a GAP 100 [%} retraced, If the market GAPs Up today and moves below the close of the previous day or GAPs down Today and moves above the Close of the previous day.

The following table presents some of the results of our study, that we created about GAP retraces.

For the study we used the daily data of the NASDAQ100 index – following ETF symbol, the QQQQ. Similar results could be attained for the S&P500 index following SPY symbol.

We created four categories of GAP sizes, and four categories of GAP retraces.

First column in the table presents the probabilities, that the market retraces at least 38 [%] of the GAP.

The second column in the table presents the probabilities, that the market retraces at least 50 [%]

The third column presents the probabilities, that the market retraces at least 66 [%] of the GAP, and the last column presents the probabilities, that the market fills the GAP, or retraces 100 [%] of it sometimes during the day.

Some comments and conclusions after looking at the results:

- Most of the time, for smaller GAPs we have a very high probability, that the market will retrace 38 [%] or even 50 [%] of those gaps, so if we would like to play in the direction of the GAP, we do not necessarily need to hurry or can get better prices with a little bit of patience.

- This also mean, that in many cases playing against the GAP right from the open might be a very successful short – term play intraday trading strategy.

In this case shooting for at least a 62 [%] retracement might have a good win probability, as the probability numbers for at least a 50 [%] retracement is only marginally bigger than the probability of at least a 62 [%] retracement.

- Logically , the bigger the GAP, the smaller the probability that it will be retraced 100 [%] during the day. For GAPs, above 1 [%] the probability, that it will be completely retraced during the day is only 50.6 [%], roughly 50 fifty /fifty.

This also explains, why do we have relatively little chance, if the market GAPs against the predicted direction with a bigger than 1 [%] GAP.

- We selected the 38 [%], the 50 [%], the 68 [%] and the 100 [%] as they are close to the Fibonacci retracement levels. The importance of the Fibonacci numbers relatively low for GAPs, smaller than 0.5 [%], as we have almost 80 [%] probability that the market will retrace 100 [%] of those GAPS sometime during the day.

- In the above study we did not take into account any other market parameters, that might have some impact on the actual probabilities. Some of these could be like:

o The direction of the SMA20 / SMA50 / SMA200 averages

o The Information, that the daily price levels are Above / Below these averages

o The information, that the predictor predicted the direction in the direction of the GAP or against the direction of the GAP.

o Any other indicators or market data, or economic data.

Taking these into account one by one at a time we found that the difference in the actual probability might be different by 3 – 7 [%]

Now having the retracement / Fill probabilities for different settings as the next step we would like to get answer for the following question:

Considering, that the market retraces at least the 38 / 50 / 62 / 100 [%] of the GAP already occurred during the day. What is the probability than, that the market takes a 180 degree turn and will close above the market open (in case of a GAP UP ) or Below the market open (In case of a GAP Down).

The following table present the results:

Some of the conclusions from the data:

- Even after a Big GAP (Up / Down) and a 100 [%] retracement of that we still have 18.7 [%] probability, that the market turns, and turns in a big way, by moving back above the open (In case of a GAP UP) or below the open (in case of a GAP Down)

- The probability, that the market will presents a big turn considerably decreases, IF we reach the previous day’s close, retracing 100 [%] of the GAP first.

Presenting a 100 [%] retracement is like putting the market in a different trajectory.

- If the market turns back toward the original direction of the GAP without a 100 [%] retracement, than the actual retracement level will have little determining factor for the probability of reaching the opening level. It is roughly 40 [%] for most GAPs, smaller than 1 [%]

Enjoy Your Trading.