Stocks & Commodities V. 27:11 (22-27): Short-Term Profits With Gap Trading by Glaister Welsh

Short-Term Profits With Gap Trading by Glaister Welsh

Mispriced stocks are often caused by gaps, which you can take advantage of by applying a strategy that generates above-average returns while reducing your risk. Check it out.

A convergence trading strategy is based on the theory that when the price of a stock or stock portfolio significantly deviates from its long-term trend, it will return to its original trend sooner or later. Normally, convergence trades tend to move prices toward their long-term equilibrium values and, thereby, stabilize markets. However, some research suggests that if convergence trades are “unwound” prematurely, asset prices would tend to diverge further from their equilibrium values instead of converging. Convergence traders with logarithmic utility functions could trade in ways that stabilize markets but will amplify market shocks if the shocks are large enough to severely deplete their capital.

Additional research also shows that asset prices converge more slowly to their fundamental levels when the traders’ capital has been impaired by trading losses. Not only that, if stocks are underpriced, abnormal returns can be generated over a three-year period as arbitrageurs act to eliminate the inconsistency in stock price.

So how can traders use this?

LEAN SIX SIGMA

I applied a Lean Six Sigma (Lss) approach for the definition and analysis of this work. While Lss tools and techniques are typically used to improve industrial and service processes, I utilized the tools to improve a stock trading plan based on the hypothesis that gapping stocks will eventually converge to some normal trading range.