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The Multiple-Day Gap Signal (Multigap)

The traditional or basic buy/sell gap signal has already been discussed in this chapter. The gap approach has merit; however, there is a variation on the theme of the gap trade method that may prove even more valuable. While the basic gap method is designed for day trading, there is a way to capitalize on the gap idea for short-term trades. The multigap is also useful for day trading, particularly in S&P futures where the accuracy and average trade increase. (I will show these statistics later after I explain the multigap method in detail.)

As you know, the basic gap signal occurs when a market opens below the low of its previous day and then penetrates the low on the way back up (buy signal) or when a market opens above the high of its previous day and then penetrates the high on the way back down. Entry is made on a buy or sell stop and exit is on the close of trading. In active markets such as S&P futures, this methodology has merit and back-tests profitably over many years of historical data. My recent test of the gap day trading method in S&P futures back to 1982 shows the system as having been correct 60 percent of the time with an average profit per trade of $497. This is very respectable for a day-trading method. There are ways to boost this figure to over 80 percent with nearly twice the average trade.

The Multigap Explained

The multigap is a simple method. Rather than generate a signal based on an opening gap above or below the previous day's high or low, the signal is generated based on an opening gap above or below the highest high or the lowest low of the last x number of days. The x is determined for each market based on the volatility characteristics of the market. What will work for S&P because of its volatility will not necessarily work for oats. Ideal examples of the multigap buy and sell signals are shown, respectively, in Figures 12-12 and 12-13.

Rules of the Multigap Method

Following are some rules to keep in mind when using the multi-gap method:

ж If a market opens below its lowest low of the last x days, then buy on a penetration back up through the low by x ticks.

ж If a market opens above its highest high of the last x days, then sell short on a penetration back down through the high by x ticks.

ж Exit on a predetermined risk management stop loss, on the close of the day, or on the nth profitable opening

Note that by x days I mean a given number of days as defined for the indicated market. The x days can be different for buy signals and for sell signals. The nth profitable opening is also determined by market. By a profitable opening I mean an opening price that is above the buy price or below the sell short price. You simply count the number of days in which the opening was profitable. Then on the nth profitable opening, you exit (unless you have been stopped out first). See Figures 12-14 and 12-15.

This is a truly simple approach that I believe has considerable merit for position traders. You might want to take some time to evaluate this method. (See Figures 12-16 through 12-18 for additional historical test results.)

As mentioned, based on my initial historical testing in S&P futures from 1982 through 1998,1 show an accuracy of 60 percent with an average trade of $482 (slippage and commission deducted). The entry parameters are 9 days for buy signals and 2 days for sell signals. In order to find the best fit^you will need to adjust gap size and penetration size. Hence, the restilts could be even better than what is stated above. As you can see, this is an improvement on the basic gap method previously described. See Figures 12-16 and 12-17.

Holding beyond the Day Time Frame (Exit on Nth Profitable Opening)

Sometimes it pays to hold slightly beyond the time frame of one day. Using the multigap method in S&P and exiting on the first profitable opening, my initial historical testing in S&P futures from 1982 through 1998 shows an accuracy of 85 percent with an average trade of $780 (slippage and commissions deducted) based on a window of 9 days for buy signals, 2 days for sell signals, and a few more parameters for stop-loss and amount of gap penetration. See Figure 12-18.

In some markets, gap trades that show a poor record of success when closed out at the end of the day can improve dramatically using the multigap method. In T-bond futures, for example, the simple gap method back-test in T-bonds shows a 50 percent accuracy with an average trade of only $56. But holding the trade with an exit on the first profitable opening yields an 85 percent with an average trade of over $224 for the period from 1978 to 1998.

As another example, the basic gap trade in coffee futures produces an average trade of $137 with 54 percent accuracy if exited on the close. However, using the multigap method, accuracy increases to 67 percent with an average trade of $424 over the period from August 1973 through January 1998.

Take a little time to review this approach in a number of different markets. You may find it worth your while to pursue it.