Looking through the gap
Study of opening gaps in Nifty stocks shows a big move is in the offing
Attention folks, get ready for a big swing on the Street. An analysis of stock ‘gaps’ for the past 18 months indicates that a big move is in the offing over the next one month. Gaps, defined as the difference between the opening price of a stock compared with its previous close, is an important tool used by technical analysts to chart the course of a stock. It is also a good indicator of market sentiment.
An Outlook Profit study of Nifty 50 stocks that opened with gaps of over 1 per cent (up or down) over the past one-and-half years shows that every time there is a spike in the number of stocks that open with gaps, a big market move follows.
In July 2008, the total number of gap openings stood at 580, the highest since March 2007 — the period from which we analysed the data. The second-highest number of gap openings was seen in August 2007, after which the Nifty gained more than 13 per cent within a month.
In January 2008, when the market fell from its peak, it was led by a high number of gap openings (See chart). For instance, the third week of January, over 40 stocks from the Nifty pack opened with a gap of more than 1 per cent. The number of stocks that opened with gaps during the month was 539.
In the following month, too, pessimism continued with gap openings at 524 and the Nifty ended 18 per cent.
Theoretically speaking, gaps are formed in reaction to developments after the markets close. One key reason the number of occurrences
of gaps was heightened last month was the heavy flow
of news. Since the markets were uncertain, news developments dictated market moves. “Last month was eventful — the vote of confidence for the government, volatility in crude prices, the rate hike, and quarterly results kept markets on the edge resulting in rise in gaps:’ says Yogesh Radke, derivative analyst, Edelweiss Capital.
Though gaps have often led to major market moves, the direction of the move can’t be predicted. However, for traders, the anticipation of a move is good enough to position themselves with the use of derivative strategies like strangles, which turn profitable if the market moves out of a certain range.
Some experts suggest that gaps are often created by amateur traders as they are the first to react to news. Unfilled gaps (if the stock does not come back to previous closing level) act as resistance or support for stocks. On the contrary, if the market surpasses the gap, the move is seen as strong enough to be termed as a trend reversal.
According to Sushil Kedia, head-institutional equities at K&A Securities, gap-up or gap-down openings are primarily a result of reactive trading to news by leveraged amateurs.
Different markets and securities display differing gap characteristics, which is reflective of the unique character of participants in that particular market or security, says Kedia. Hang Seng, for example, displays the largest number of gaps among major markets; hinting at a larger share of trades originating from amateur traders.
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