A morning gap occurs whenever there is a difference in price between the previous day’s close and the open in the morning. Theoretically, there are really two of these types of conditions that occur. A true gap is where the open is above or below the previous day’s high or low respectively. On a daily chart (chart provided compliments of TradeStation) this would leave a hole in the chart as in the image below.

As you can see in the graphic, the high of the third bar and the low of the fourth have a gap which is marked out by the horizontal lines.

Another case, that I believe was coined by Larry Williams, is where the open is above or below the previous day’s close but the price is not above or below the previous day’s high or low. He called this a lapse, so we will use that term. On an intraday chart, a lapse looks like this.

On the lapse chart we can see the market opened down, but not below the previous day’s low (as indicated by the horizontal line).

The difference between a gap and a lapse is important. A gap is a different type of event than a lapse. A gap takes much more risk for traders to take price outside the previous day’s range. As a result, gaps are often driven by more powerful forces than lapses.

It is commonly said, as a rule, gaps, and lapses, get covered. What this means is, at some point, the market will go back over that area and fill it. Conventional wisdom says, more often than not, a small gap or lapse will be filled in relatively short order. Further, the conventional viewpoint says on the day, and often the very morning it occurs, a gap or lapse will tend to be filled. It is also maintained by the majority of traders out there that Gaps or lapses of large magnitude can “run” away and not be covered in the near term.

Some traders specialize in this area alone and only trade morning gaps and lapses. If they are to be successful at what they do, then the truth about gaps and lapses in general must be known. Let’s take a look (over the last two year period) and see if we can get to the bottom of this.

The graphic below shows the equity curve of a simple trading system using one Emini S&P contract. It buys down gaps and sells up gaps without regard to the magnitude of the gap. On an up gap, it will exit the short position if the gap closes to within the highest of the previous 5 (5 minute) bars from the previous day. If it fails to achieve this at any point during the day, it exits on the close. Similarly, for the down gap, it will exit the long position if the gap closes to within the lowest of the previous 5 (5 minute) bars from the previous day. If it fails to achieve this at any point during the day, it exits on the close.

As you can see from the graph, there were just over 90 occurrences in the last couple years of true gaps. The result of trading these according to conventional wisdom resulted in a loss. Over all, this system was 48% profitable. There were periods where doing the opposite could have been very profitable and periods where conventional wisdom held. As a general rule, for gaps then, we have a pretty much random result.

Let’s look at the case for Lapse conditions. The rules are the same as noted above for gaps. Trades are only allowed at or before 935AM Eastern time.

We can see there were about 140 cases of lapses in about the last two years. The result of trading according to conventional wisdom would have taken us on a wild ride indeed. During the period covering somewhere about the first year, it would have lost around $8000, and during the most recent year it would have made around $5,000. This would only be true if you had been smart enough to switch strategies at exactly the right time. Not a very likely sequence of events. This test also came up at about 48% accurate, again showing this approach to be more or less random.

What if we were to parse out the gaps according to certain magnitudes and trading only the smaller gaps or lapses?

As can be seen from the above optimization grid (compliments of TradeStation), the test for only trading smaller gaps did not pan out. Some were profitable and some were not, with only 3 out of 19 tests being profitable. This again confirms, over the last two years, gaps are more likely to run than cover. Are bigger gaps more likely to run than smaller ones? The data suggests a gap greater than 9 points may be more likely to run than gaps less than 9 points, however, the distribution of returns above that point does not increase with increased gap size. Therefore, this conventional wisdom is only partially true, if at all.

Does this article claim the trading of gaps to be of no value? Absolutely not. The trading of gaps can certainly be viable if managed correctly. For example, our lapse equity curve shows a very strong linear relationship at various times. To improve upon this, one might research switching from one method to another under changing equity, or in any number of other ways. One example that could be extracted is the case for trading gaps that are more than about ½% as runaway gaps.

With a little creative thought and a couple simple research techniques such as those shown above, one could find plenty of trading opportunity in this exciting area of gap/lapse trading.

If you are a swing trader, it is of paramount importance you understand how gaps and lapses impact your trading. Typically this will impact you on entries and on overnight moves. If you are entering short, one of the best things that can happen to you is for the market to gap, or lapse up. The worst of course, is to enter short on a down gap/lapse. Because selling at a lower level increases risk on your position.

If you are already in a position, say long, and the market has a smaller magnitude gap or lapse against you, it is less likely an actionable event when compared to a case where you have a large magnitude gap going against you.

It is extremely important not to simply take conventional wisdom and act on it without first evaluating the turf on which you play. Doing so can cost you and can result in a disastrous trading record. Always research your method thoroughly before risking hard earned dollars, or enlist the help of a professional to achieve this goal.