Day trading has long been glamorized as a quick path to financial success, with many traders drawn to the allure of “easy money” by capitalizing on stocks that show significant gaps up in pre-market trading. The theory goes: if a stock is surging before the market even opens, surely it’s on a trajectory for a strong day, right? Not quite. A comprehensive historical analysis of all US stocks since 1990 tells a different story, challenging the conventional wisdom and revealing surprising insights about where the real edge lies.

Many day traders operate under the assumption that purchasing stocks experiencing a pre-market upswing—a phenomenon known as “gapping up”—will lead to quick profits by the market’s close. This strategy seems intuitive; after all, a strong pre-market performance often feels like a reliable indicator of continued upward momentum throughout the trading day. However, our extensive backtest, spanning over three decades of market data, suggests that this approach may be fundamentally flawed.

To get to the bottom of this, we established a set of criteria for a backtest aimed at uncovering the truth behind the profitability of trading gapping stocks. Here’s a brief overview of the rules we applied:

• Short stocks at the open if they meet the following conditions:
• Price greater than $5
• Average True Range (ATR) greater than $0.50
• Average volume exceeds 1 million
• Gap greater than 1x ATR
• Close positions at market close.
• Limit the maximum notional per stock to 10% of the portfolio’s Assets Under Management (AUM).

Our objective was straightforward: to determine where the true edge lies in day trading without complicating the strategy with intraday timing rules, stop-loss orders, or profit targets. The aim was to keep the backtest simple to ensure clarity in our findings.

The outcome of our analysis was eye-opening. The backtested portfolio, adhering strictly to the criteria above, would have yielded an average annual return of approximately 40%, even with a maximum drawdown of 40%. Remarkably, the overall Sharpe Ratio—a measure of risk-adjusted return—exceeded 1.50, suggesting a favorable return profile relative to the risk undertaken.

These findings indicate that the real edge lies not in joining the bandwagon of buying gapping up stocks but rather in shorting them at the open and covering at market close, under specific conditions.

It’s crucial to understand that these results don’t offer a one-size-fits-all trading strategy ready for immediate application. Factors such as borrowing costs, commission fees, and slippage need to be carefully considered before any real-world implementation. Additionally, while this study sheds light on a potential edge in shorting gapping stocks, it also underscores the importance of advanced trading rules, proper risk management, and ongoing strategy refinement.

This historical analysis challenges the conventional day trading strategies and opens up a new avenue for traders willing to look beyond popular beliefs. While trading setups like the “Gap & Go” can indeed be profitable, our study suggests that a more contrarian approach, equipped with a deeper understanding of market mechanics and disciplined strategy execution, might be the key to achieving consistent trading success.

Day trading, with its promise of quick profits, continues to attract a wide array of participants. Yet, as our study reveals, the true edge may require a shift in perspective—away from the crowded tactics and towards strategies that are backed by rigorous analysis and a nuanced understanding of market dynamics.