Trading on Correction: Rules and Results
30 June 2022
When studying stock price charts, you can often see the presence of price gaps today compared to the previous trading day. They can be seen both after the weekend and on weekdays.
A separate study on price gaps, “Does the Gap Tend to Close?” has shown that the gap closes in more than 60% of cases, and that with an increase of the price gap, the probability of its closing decreases.
Lars Tweed in his book "The psychology of finance" also paid attention to price gaps, but together with the analysis of trading volumes.
He believes that there are certain rules regarding trading volume, one of which is: "if the market opens with changes from the previous day's close with more volume, there will be a correction towards the previous close price throughout the day."
It is this rule that we will study today.
If the market opens with a gap relative to the previous day's close and with more volume, then the price will correct towards the previous day's close during the day.
Instruments: 60 US stocks (detailed list is in the appendix)
Period: 01/01/2004 – 08/01/2021
Timeframe: 1 hour (H1)
Total market entries (transactions): 62,197
Strategy
If Open1 < Close0 and V1 > V0, then we buy at the beginning of the second hour of the current day
If Open1 > Close0 and V1 > V0, then we sell at the beginning of the second hour of the current day
where: Open1 is the opening price of the first hour of the current day
Close0 - the closing price of the previous day
V0 – volume of the last hour of the previous day
V1 – volume of the first hour of the current day
A gap value between the current and the previous day (GAP, %) is calculated as follows:
GAP = | Open1 - Close0 | / Close0 * 100
Consider the following gaps’ values:
GAP >= 0; 0,5; 1; 3; 5; 7; 10.
Closing a position
- on Close of the last hour of the current day
Analysis of the obtained results
We will evaluate the results according to the following criteria:
The rate of return reflects the relative change in the quotations of financial instruments in percentage. A positive value of the rate of return indicates the profitability of the strategy, negative - about the loss.
The rate of return (R) of a financial instrument is calculated using the formula:
where:
n is the number of transactions;
P (%) – the percentage of change in the quotation of the financial instrument at the time of fixing the position, is calculated as follows:
for buy positions
P (%) = (position closing price - position opening price) / position opening price * 100%
for sell positions
P (%) = (position opening price - position closing price) / position opening price * 100%
The results are presented in diagrams:
The strategy of trading on correction has not brought positive results for the considered period of time. On the contrary, the rate of return of the strategy, together with the number of transactions and probability of closing the gap, decreases with an increase of the price gap.
With a gap of 7%, the rate of return reaches a significant negative value of -0.3%. This means that with "large" gaps, the price does not correct during the day, but moves in the direction of these gaps.
In such cases, the strategy of the opposite entry into the market is applicable. That is, instead of transactions for buying, transactions for sales are opened, and vice versa.
The effectiveness of the strategy has been revealed under the following conditions: there is a large price gap on a growing volume, and the entry is carried out in the continuation of the movement.
Detailed results are presented in the appendix.
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