The Predictive Power of Price Gaps

Abstract: Price gaps are identified by studying trading ranges, which is the spread between a stock's highest and lowest traded price over a trading day. If the trading ranges of two consecutive days do not overlap, a price gap has occurred. A positive gap is when the lowest traded price of the day is higher than the highest traded price of the precedent day. For negative gaps, the highest traded price of the day is lower than the lowest traded price the day before. Our hypothesis is that abnormal returns can be generated from buying stocks after a positive gap and from short-selling stocks after a negative gap. Using transaction data from the Swedish stock market from 2000 through 2010, we test our hypothesis. First we map returns and abnormal returns, generated from risk-adjusting models, for holding periods of one to five days. The abnormal returns are then the base for executed regressions, run in order to test the explanatory power of positive and negative price gaps. From our analysis, we find support for our hypothesis that trading on positive gaps generates abnormal returns. These abnormal returns persist even after taking transaction costs into account. The same support is not found for negative gaps. According to our findings, price gaps seem to constitute an anomaly.