As per reader request, I conducted a quick summary of all gaps in the DIA (Dow Jones ETF) for the month of January to see what would have happened if a trader faded all gaps.

The question is the following:

How many days in January had overnight gaps in the DIA (Dow Jones index), and second how many (and what percent) of those gaps filled.

I also added a very quick, very unscientific calculation of returns had a trader attempted to fade a gap.

Let’s start with the hard facts:

13 of the 20 trading days in January experienced some sort of gap greater than 10 Dow Points ($0.10 DIA points); thus 65% of trading days in January experienced an overnight market gap.

Of these 13 overnight gaps, 9 of the 13 experienced a complete and total gap fill, representing 70% of all gaps filled.

Let’s view this in a quick table:

The following days resulted in some sort of overnight gap greater than 10 Dow Points in January, 2008:

Legend:

BLACK: Not a Trading Day
GREEN: Successful Gap Fade
RED: Failed Gap Fade
WHITE: No Gap Fade

Now, onto the subjective material:

I took each gap fade day and tried to assess visually the potential profit or loss for each day. For successful gaps, I took the intraday low and counted price to yesterday’s close only.

For failed gap fade trades, I took the maximum stop-loss size of $0.50 (50 Dow Points) for an arbitrary stop-loss, assuming that entry took place at or near the gap open. The losing gaps were all at or near 100 Dow points (or $1.00 DIA).

Here are the non-scientific statistics based on my analysis only: (no representation that these numbers are perfect or near perfect, but only represent possibilities designed to give you an idea of a gap-fade strategy that does not include commissions):

January

Total Wins: $14.40

Total Losses: $2.00

Total Outcome: $12.20

Recall that $1.00 for the DIA (Diamonds ETF) is equivalent to 100 points on the Dow Jones Index.

SUMMARY:

Of the 20 trading days in January, 13 (65%) of those days produced gaps in the DIA, and of those 9 (70%) of those gaps filled for a profit using the classic “fade the gap” strategy.

Based on crude and unscientific statistics, traders using this strategy had the potentiall to gain $12.20 from all trades (13) taken!

Thoughts:

How would volume confirm? What about other indicators? What about morning news report? What about size of the initial gap? How would you place stops?

All of these questions could help us filter out gap trades, but would complicate the simplicity of the classic “fade the gap” strategy.

While nothing is ever 100% in trading, the classic “fade the gap” strategy produced an edge both in percentage and potential dollar profit in the month of January, 2008.