Marketsci on what overnight gaps tell us about the stock market

  1. The idea that the overnight market (close to open) doesn’t influence the daytime market (open to close) is usually correct, but NOT when the overnight market is moving violently like it has recently.
  2. Large gaps down exhibit a relatively strong negative correlation to subsequent daytime changes indicating a tendency to reverse some of the overnight gap in the daytime. I haven’t shown it in these statistics, but the larger the gap down, the higher the average return and the more negative the correlation (but also the higher the volatility) of the daytime reversal.
  3. Large gaps up do not exhibit a consistent influence in all market conditions. Also not reflected in these statistics is that as the size of the gap up increases, the correlation to the daytime market becomes more and more asymmetrical based on the broader trend. In up trending markets, these very large gaps up exhibit strong follow-through (positive correlation), but in down trending markets, very strong reversal (negative correlation).’

Dr. Brett Steenbarger on market bottom

Bottoms are made when selling becomes exhausted and long-term participants perceive value and lift stocks sharply off their lows. That exhaustion can occur over a period of months, as fewer stocks and sectors make new lows over time and individual stocks and sectors find fresh buying interest. Thus far, we’re not seeing such selling exhaustion; weakness has, so far, begotten further weakness. While it is tempting to call market bottoms and pick up bargains, all we can say Wednesday is that a historically weak market just got weaker.”

How to define a stop loss?

“Place your stops at a point that, if reached, will reasonably indicate that the trade is wrong, not at a point determined primarily by the maximum dollar amount you are willing to lose.”

Bruce Kovner

If you are using automated trading systems, the most appropriate approach for stop loss’ defining is applying Average True Range. For example you might use 1.5 times or 2 times 10 days ATR. It will depend on your trading horizon.

If you are proprietary trader (most likely trend follower), it is reasonable to put your stop loss 10-20 cents below major area of support. Again, the area of support would be defined by your investing horizon.

Honor your stops!

In high volatile environment (now), you would often be shaken out of positions, only to see them reverse back in the desired direction. This is not a reason not to honor your stop losses. It is just a reminder that either your timing was inappropriate or that you don’t have an edge in the current market environment and therefore you shouldn’t participate until things change. There are times to buy, there are times to sell, there are times to do nothing.

In bear market, honoring your stop loss will save you form disaster. It will assist you to preserve capital, so you could live to trade another day. In bull market, it will free out money for better trading opportunities.

The only reason to hold a stock in your portfolio is if you would buy it at its current level and there aren’t any better opportunities for your money.

We are experiencing a rare event of market destruction that will lay down the foundations for the greatest wealth-building opportunities in our life time.

After the darkest hour of the night, the sun will rise again.

Reason to buy

“If you really think the stock is going to make a big move – and that should be the only reason you are buying the stock to begin with – then there is no reason to haggle over an eighth of a point. Just buy the stock. The same thing applies to the downside; if you think the stock is going to drop, just sell it.”

David Ryan