For the last year or so, the market has often shown a tendency to open with perceptible gaps. This phenomenon is due to several reasons. However, sooner than trying to decipher causes, a trader would be much more concerned with anticipating and managing the patterns.
As a rule of thumb, the Nifty seems to open up or down by around 0.5 per cent, compared to its previous close. On swing sessions, when it is reflecting major events, the gaps can be much larger and thus, the arithmetical mean is a lot more. As the average high-low movement in a session is around 1.5-2.5 per cent, the opening ‘error’ is quite significant.
What does this mean for a trader, who is either intending to hold an overnight position, or analysing the closing data in order to conceive a strategy for the coming session? Keeping more margin is one thing. Given equities futures leverage of 10:1, an extra 10 per cent margin in hand seems to be a must for any overnight futures position.
Stop-losses must also be adjusted accordingly. Any stop that is within, say, one per cent of the closing price, is in danger of being knocked out before you ‘wake up’. If you're in the habit of setting mental stop-losses, as in noting price levels where you intend to exit positions, a larger range of error also needs to be incorporated in all your calculations.
Any options trader must do delta calculations on overnight positions – this is normal. But if there is an everyday expectation that the market will open at plus/minus 0.5 per cent away from the previous close, the calculations become much higher priority.
Close to money options show massive changes in premia in these circumstances. Assume that at-the-money, near-month Nifty options have a delta of around 0.5, and the premium for at-the-money is usually around 1.5-2 per cent of the strike price. This means that an opening gap of +/- 0.5 per cent will translate into a change of around 15-20 per cent in the opening at-the-money premia on a daily basis. Modelling this into calculations is quite daunting, especially for an option-seller.
A pure technical analyst also has to include the likelihood of gaps in his trading strategy. In practice, I've started using Bollinger Bands of one per cent around the closing value, which is an unconventional width for a Bollinger Band. It seems to be a reasonable method of making rough and ready judgements about likely opening levels.
But there are certainly more sophisticated ways to adjusting for this sort of movement. While the excess volatility certainly increases the risk, being prepared for it should also help the trader to generate excess returns.
The author is a technical and equity analyst
