The Gap Guy

Though I've never traded my gap system during a bear market, I designed it to work well regardless of the macro market conditions. This past year was the first time my "bear" assumptions were tested with real capital at risk.

For the year, my primary gap trading was up +36% (trading a max of 1 contract per $10,000 in equity, including commissions). For audit purposes, I also setup a smaller "gap only" account at the beginning of 2008. The smaller account started with $50,000 in actual (not simulated) account equity and I traded it twice as aggressively by using 1 contract per every $5,000 in account equity (this is aggressive and something I generally do not recommend for others). This “2x account” ended the year up a non-compounded:  +72% (+ $36,353)

These returns were generated by only trading the opening gap and only trading signals that I posted prior to the opening (and my entry) for members.  All other day trading activity was conducted in separate accounts and not included in these numbers. The chart below is a comparison of my non-compounded returns with that of the SPY (S&P 500 ETF) assuming one had simply bought and held it for the year.

For you fellow numbers geeks, here's a breakdown of my 2008 gap trading (1x account):

- Total time in market for the year: 1.46% (cumulative time in market for all trades)

- Win rate: 66% (62/94 total trades)

- Largest drawdown: 8.5% (occurred from 1/18/08 to 2/12/08)

- Winning months: 10 (avg: +4.17%)

- Losing months:  2 (avg: -2.79%)

- Longs, win rate: 73% (24/33) for 9.4% net return (26% of total profits)

- Shorts, win rate: 64% (39/61) for 26.7% net return (74% of total profits)

- Full size win rate: 82% (23/28) for 32.8% net return (91% of total profits)

- Partial size win rate: 59% (39/66) for 3.3% net return (9% of total profits)

- Avg time per trade: 1 hr, 4 minutes

- Avg win: +1.56%

- Avg loss: -1.83%

- Win/loss ratio: .84

- Largest winner: +4.43%

- Largest loss: -4.05 %

- Good calls: 73 (i.e. losing gap fades that I avoided)

- Missed: 57 (i.e. winning gap fades that I passed on)

So what did I learn in 2008? Many things about my system, the markets and even me, but three stand out:

1) "There is nothing to fear, but fear itself"
Ironically FDR (U.S. President in the 1930's) said this in his inaugural address when discussing the Great Depression, but it also applies to my gap trading and volatility. From January through August, the average size gap was 7 pts, and I averaged 9 trades per month with a win rate of 66% (49/74). The average winner was $230 per contract and the average time per trade was 1 hr and 9 minutes. My cumulative net returns through August: +29%.

From September through year end, the average size gap more than doubled to over 15 pts, but my win rate remained steady at 65% (13/20). Interestingly, the number of trades declined to an average of 5 per month, but the size of the average winner increased by 60% to $370, totally offsetting the reduction in signals. However, my profits for the last 4 months only totaled +7%.

Why only 7%? Because I reduced my maximum size trade for the last four months to HALF of my normal "full" size due to uncertainty regarding the extreme volatility. This means that I took NO full size trades during the last 4 months of the year. In fact, I traded ¼ size 12 times and ½ size 8 times. I would have finished the year up about 44% (instead of 36%) had I simply used my standard position sizing rules through the volatile last 4 months.

Do I regret second-guessing my system? Nope. I had never personally traded gaps and risked capital during such volatile times. Why trade and “hope” that Otis (my system) continued to perform well? The prudent course of action was to reduce position size and avoid any chance of experiencing a record drawdown. In retrospect, Otis performed very well and now I know.

2) There's more work to be done.
I spent an awful lot of time and effort this past year preparing, executing and managing trades in which I had identified enough risk to warrant reducing my position size. These 66 trades generated a whopping 3.3% return for the year. Clearly, I need to stop trading these mediocre setups and spend more time finding the jewels.

3) Short term trading = long term profits.
I know this sounds totally self-promotional, but think about it. I was in the market for about 1.5% of the entire year, carried no overnight risk (which means I slept extremely well) and outperformed the S&P 500 by 75% in my 1x account and 110% in my 2x account. How I wish that I had traded gaps in my IRA - I will starting in 2009 that's for sure. Best of all I still have room to improve my system.

In summary, 2008 was an extraordinary year in every sense and like most, I am glad it is over. I am not sure what 2009 what will bring, but I am hoping that it stays range bound. Gap trading can be quite lucrative when the markets struggle to make trending moves.