I received an interesting note from Dr. Steven F. over the weekend who observed the SPY gap open put it above it’s upper Bollinger Band on the gap. For an index to gap open outside of its Bollinger Band, price will almost always need to be somewhat stretched already. It would seem logical that a gap up into an already short-term overbought condition would be a likely candidate for a reversal. I decided to test.

The criteria was simple. A gap up over the upper Bollinger Band would signal a short entry. The trade would be exited near the close of the day. Looking back to 1998 in the SPY I was able to identify 79 such instances. There were 43 (54%) winners and 36 losers. The average winner made 0.56% and the average loser lost 0.50%. The profit factor was a modest 1.34.

I then broke it down by instances above and below the 200-day moving average. Above the 200-day moving average there have been 62 instances of a gap up above the Bollinger Band. Shorting these and covering on the close resulted in 53% winners. Winners outsized losers by 0.57% to 0.38%. The profit factor was a decent 1.7.

The trouble occurred with this less than “Outstanding” Gap Band strategy when it was attempted below the 200-day moving average. There were 17 instances. Ten winners, but the average loss was 1.0% vs. an average gain of 0.5%. Overall a losing strategy below the 200ma.

As with previous gap studies, it appears gaps up in long-term downtrends are dangerous to try and short. While it would’ve worked out on Friday, you always need to be wary of a short-covering rally or trend day up.

Initial results of buying a gap down below the lower Bollinger Band appear better. I will look at them in more detail at a later time.