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.

Much has been written about various cycles in the stock market, other commodities and investments.

One very famous example is the Delta Phenomenon, a trading book that sold huge quantities at $175 per copy (and some for many many times that). The basic idea has to do with lunar cycles.

Lunar cycles? Stock market? About now, I can hear you saying, “what a bunch of #^$%.”, but bear with me because, if you are of the hard core left brained approach to such things, I would like to point out that even the Atlanta Federal Reserve has published a white paper on the geomagnetic influences on stock market cycles (http://www.frbatlanta.org/invoke.cfm?objectid=AFD46B63-2852-4812-BE83E6D0C777F4BF&method=display).

I have done a tremendous amount of research in this area, devoting several years of my life to this very topic. Much new research in astrophysics is revealing we really live in a very electric universe (http://www.thunderbolts.info/home.htm). I have been able to achieve winning percentages in the 90% range on longer time frames using geomagnetic data to time the stock market. So, don’t knock it til you try it ;-)

Modern world culture has largely abandoned the use of what our forefathers commonly used, and that is the lunar calendar. Many ancient cultures, such as the Chinese or those of the Jewish faith, for example, still retain this tradition. Many Buddhist traditions carry certain days of the lunar month as having certain significance. This is also true in Indian writings such as the Vedas.

Is there some wisdom to counting out events according to lunar cycles instead of only solar ones as we do here in the west? Does reliance on a purely solar calendar hide things from us that would otherwise be obvious on another interval? I certainly think it does. After all, the moon, for example, surely influences fluid flow, and we are largely made, of water. The moon and sun also significantly influence charges on the ionosphere that impact our environment. So, these things all tie together. As mentioned, physics is now coming to find more detailed reasons to believe electromagnetism and gravity are really opposite sides of the same coin. For more on this, you might enjoy the articles of Myles Mathis at http://www.milesmathis.com/

There are many physical cycles we could analyze that influence human behavior as it relates to the stock market. As an exercise, let’s see if we can find any truth to stock market cycles that are based around the lunar month (from new moon to new moon). There are many such cycles we could analyze, but this one will suffice to show some interesting cycles and, how one might go about discovering them. Then, you can write me to tell me what you have found;-)

To start with, in trying to find the data to do these tests, I quickly found there was no commercially available software that could export any reasonable amount of data. So I developed my own. I call it the “Astro Data Generator.” It will generate any data you need for just about any planetary body in the solar system (ie. Declination , longitude, speed and distance etc.).

The new moon is simply an event that occurs when the sun and the moon rise at the same time. So I export data for the sun and moon and use my spreadsheet to identify when they cross. Then, from that point, I will count forward, buying and selling the S&P 500 (the best example of the tradable US stock market as a whole) at each point (daily) in the cycle. Here is what I found:

As can be seen in the above table, there is an excellent bias around purchasing the 23^rd or 24^th day of the lunar month and holding into the 4^th day of the lunar month. We can also see a bias as follows:

5th-14th short, 15-17 long and 18-21 short.

As you can see, there are clearly cycles present here. In fact, this particular end of month buying and carrying over into the new month bias is well known on a calendar basis. However, I have never seen a study done identifying an end of lunar month pattern like we have done here. It is a unique study. It is often reasoned that this solar calendar effect is due to “window dressing” by fund managers to make their portfolios look better. Seeing this lunar bias makes me wonder whether it is in fact something altogether different. To get to the bottom of it would require more research that is beyond the scope of this article.

This is certainly not trading advice at this point. For example, to turn this into a tradable pattern, I would do some statistical analysis to see the distribution of trades. Either way, it tells us that much more about human behavioral (stock market) cycles that, could themselves be driven by external forces that are cyclical themselves.

Research in the area of stock market cycles that are driven by other external phenomena is a very fruitful area of research that can lead to substantial benefit. Hopefully the future will bring more thoughtful minds into this arena.

10 AM Morning Update for 9/23/2008

Please be aware, without respect to the EMF forecast,
Price action at this time is bearish suggesting potential
downside movement.

** ALERT  **  Time= 1005: The current price action is bearish.
Short positions taken on upside rallies may be beneficial
between now and the close.

RESULTS: +33 points

It never ceases to amaze me how people put strange verbal terms to things that would otherwise be extremely painful.  Let’s take the trading term “Drawdown” for example.  What on earth is that supposed to mean?  I can tell you this.  When I lose money, I lost money.  It is just that simple.

You can call it anything you want, but somehow, calling it “drawdown” seems to make it all better again.  Yes, “drawdown” is a forward looking term and those of you who know me, know I approve of future thinking.  It is always the question, what is developing now, that makes the future likely to be as anticipated that makes all the difference in my trading.

If I am trading a trading system I developed, my first thought on parameter selection is what is the market condition likely to be in the near future?  Will it be more volatile?  Will it be choppy?  It is this kind of thinking that helps me to decide which systems I am going to be trading tomorrow and with which parameters.

I will run tests that show me how the parameters shift under various circumstances and I will anticipate this.  It is this kind of thinking that has made a huge difference for me; anticipatory thought.

But the term “drawdown” also carries with it, without regard to your method or its viability, the seemingly all saving idea that you will recover from where you are.  After all, it is just a drawdown.  Well, if it went down, it certainly will in all likelihood go back up, right?  After all, the great master did say, as you believe, so shall it be done.

So is “Drawdown” really a dangerous word to be using?   Yes, I believe it is.  Because it ignores that larger picture of what really is an efficacious approach to trading.  I think it is a conspiracy against newbie traders to keep them from realizing the big picture of money management.

If you really want to get real about it, go read this techno babble that detaches it even more from the experience (http://www.en.wikipedia.org/wiki/Drawdown_(economics)) of losing real money.  After getting your PhD in detached financial verbosity, you might be able to get a job teaching trading to a bunch of unsuspecting students to try to pay back all the money you lost trading in the real world ;-)

Traders have to deal with reality every day. If not winning, then you certainly are losing. It is just that simple!  Trading is the most basic game in the world, but it requires a solid understanding of oneself and the environment around you.  Challenge the terms that are being presented to you and the environment you operate in as a trader and free yourself from biases that can keep you down.

I have heard people refer to the market being “overbought” or “oversold” for as long as I have been a student of the markets. To be sure, only one of the two terms has any credibility and that is oversold. There is one case for this, and that is when the market is trading at zero. That is oversold! It is the only real case. Since the market (S&P 500) is trading at 1250 as I write this, I guess that isn’t likely to occur today (or at any time in the near future for that matter).

Unfortunately, for those who wish to use the term “overbought”, it is important to note that the market has unlimited upside potential. So this case can never really occur. So there is no such thing as overbought at all.

I suppose people mean some kind of relative term when they speak in this way. In this manner, “overbought” translates to the market is high (higher than it was before). “Oversold” would translate to mean it is lower than it was before. Since the market alternates in a range a huge percentage of the time, one would conclude that such terms are even more un- meaningful than would otherwise have been the case.

Let’s look at it from the other side of the coin. For 1990-2000 the market remained overbought for a period of about ten years. I suppose there were occurrences within the minutia that could have been relatively higher or lower compared to the past, but what is the use of a term that draws your attention to the obvious.

That’s why I decided to coin a couple new terms, to put a new perspective on the whole thing. This is really quite exciting. A revolutionary new concept. My new terms (and feel free to use them widely to get the buzz going) are “Underbought” and “Undersold”.

Yes, I know, undersold is already in use. Well, not in this proprietary sense in which I intend its important new meaning. You see, “undersold” is the opposite of “underbought.”

So what is this “Underbought?” Quite simply, it is when the market has not raised enough to be where it will be in the future. This means “undersold” occurs when the market has not declined enough to be where it will be at in the future. So these important key terms carry a whole different kind of meaning to their (rather meaningless) counterparts “overbought” and “oversold.”

You see, “overbought” and “oversold” look at the past to decide where you are now. But underbought and undersold, look to the future to tell you where you ought to be. This is a huge difference! This is especially true since it is only the future price (with respect to where we are now, or have entered the market) that has any meaningful value to us at all!

I want to start a movement of future looking market participants that don’t dwell on the past. Let’s get over it and move on. The fact is the most successful investors in the world are forward looking market participants. They trade developing trends in the markets. They are anticipatory investors.

This means that most people who are not successful in the markets spend their time oriented to the past. Conducting “backtests” of data to see how the future will be. Ouch.
So I vow today to never say “overbought” or “oversold” again and give myself to the infinite future that stands before me. Its “underbought” and “undersold” from here on out baby!

Please join me in the revolution to make these important new trading terms a solid reality!

Let’s face it. Recently, the market is more anti-persistent than ever. It just doesn’t trend at all. If we can get a 2-3 day move in one direction, it is remarkable. Most of the time, it is just moving sideways. During these times money management becomes more important than ever; protecting the gains you have made.

When trading the forecasts from the EminiForecaster service, one of the first things I want to know is whether any key levels (from the updates section of the member’s area) have been hit during the week. If a key level is hit and a strong reaction occurs contrary to the forecasted direction, it tells me to get serious about my risk control.

There are really three components to the service that help users benefit the most. Many people believe it is just the G-lines (our forecasts). In fact, the forecasts we post on Sunday are just a generalized cycle we see going into the next week. Every little wave inside these forecasts is not intended to be followed to a “T.” It is a directional forecast and a graphical way of showing where we see the next market turn coming.

These two factors, direction and pivot time can be seen on the forecast, but due to the fact that the bigger wave is not seen on the weekly chart, we summarize the forecast in the updates section of the site.

Another factor that requires consideration is the management of gaps. When entering trades at or around large gaps in the price on the open of the day session, it is important to note whether the market is being driven by large participation into that gap. Breadth measures such as NYSE advancers/NYSE decliners can reveal much about this. Strong values can reveal there is wide participation supporting a gap. Another factor with gaps is the magnitude of it. When you see the market gapping over 1% on the open, it is a dangerous place. Often these gaps can run, but if they begin to fail, it is important to control your losses and preserve your gains as best you can.

It is also beneficial to know what is occurring on the news front. Lately though, it seems any good news at all is hyped into a short lived rally. This occurred several weeks ago when the revised GDP numbers were released on Thursday. The news releases can be found at the bottom of the training area of the site.

There is no doubt these news releases, with supporting participation can make our forecasts be off. If the story and participation is of sufficient magnitude, it can be by large margins too.
For those who trade on any time frame, we also recently added the updates/alerts feature to the platform. This is intended to help you to confirm if the forecast is running right at the current time. It can also be used as a standalone service, because it gives excellent forecasts in its own right. Forecasts that are shorter term than the weekly forecasted G-lines.

Used together, these update/alerts, in conjunction with the G-line forecasts and the Key levels, you really have tremendous flexibility as to how you can use the service to your benefit.

As we have mentioned in other articles, it is paramount you trade in a manner consistent with your own personality. These tools make it possible to do that relatively easily. You still have to manage your risk prudently though.

As mentioned, always be sure to tighten up as the market hits key levels, in strange gaps and at forecasted turning points. Often it appears the market is not following the forecasts early in the week and it comes back to be right (snap-back). Often when this occurs, it can be due to one day being off out of the five in the forecast. Because the market has been anti-persistent, these things are more important than ever to manage your risk and identify where things are not going your way in advance.

When using the service, be sure to read the updates carefully. We might describe an aspect of the G-line that will be important to you later in the week. We never put comments in there that are idle babble, so be sure to get the most of it.

Being a successful trader requires a lot more than just buying and selling. It is a battle with the forces of the market and a battle with you to deal with your own fear and greed. To make the right decisions in this context is tough to say the least. EminiForecaster provides the tools to help you be most effective in this way and to help make your money management decisions clearer.