Option traders would know this Ebay effect as negative skew. When events change prices it is to the upside only.
Ebay may look like a perfect efficient pricing model at first glance, but time of trading anomalies reveal that it's really a skewed buyers' market. Photo: iStock
How many times have you heard that someone must win the lottery? When in truth they don't. The lottery will have had days when no-one won and a rollover occurs. Yet we are always led to believe that someone must win. Obviously eventually someone will win but it doesn't occur every week. Advertising skews our expectations and expected probabilities...markets are no different.
Currently we have positive skew to the markets, so surprise elements to the market where time is limited, for example the end of the week or public holidays where markets are shut... will be to the downside. But we can benefit from this skew and mispricing.
So if the Implied Volatility/Implied Volatlilty Ratio (IV/IVR) skew and pricing models show the current bias for market surprises is to the downside, then we should consider trades with that defensive bias. The trend may be your friend, but you might need to consider where does that leave you when things suddenly fall into a liquidity spiral....there isn't space for this particular subject here but I will come back to it in a few weeks.
Now look for inequalities in the market place where the so called efficient pricing model is flawed. Where can we benefit from the inequalities described.
A strategy that may be of interest?
Day traders bread and butter trade(s) are gap days. Using the prior day close price and compare to todays opening price on say the SP500 or FTSE100 we see events such as ex dividend dates or world macro events or even catastrophes cause gap down days. It doesn't matter what caused the gap. The fact remains a gap occurred.
15yrs of rolling data suggests that 83.9% of ALL down gaps fill within five trading days !
77% will rally to the 50% of the down gap in one wave. So we know that a long at the point of open ;-
A) The fastest return is to seek the 50% of expected gap fill.
B) Odds are that the gap will fill over the five day duration.
Can the trade be enhanced as I haven't defined any money management / stops?
It can... but consider one other factor for this trade. Should the down gap occur AND the open price is entirely below the prior day trading range. These usually occur after bank holiday periods or world catastrophe events or weekends. The gap down is the efficient pricing algos trying to reflect new values pre-market the world event etc has already happened when the markets are shut so indices are heavilly marked down. A long at the open is contrarian to the panic drop but is usually ultra profitable in the same time frames with the 50% of gap still being the fastest rate of return.
What if the market just drops from the opening bell? You still have the same strategy as the probabilities refer to a five day trading window. Make your opening trade smaller than normal and if we get a lower close scale a small trade onto the original trade. Make the opening trades at say 10% Stake size and the second at another 10 or 20% stake size.
These trades are probability and rely on no indicators so trade small as your money management technique. The profits do build and compound over the year so keep risks lower than normal trade position sizing. I don't add any more trade positions after the second opening trade.
This is a long-only trade structure and does not work with gap-up days. I will comment on those later. Also weekly dated options can be superb for these trades.
Looking at gaps is something for another day. Photo: iStock