Going Long on Gap Ups? Really?

On Friday, February 26, 2010 an article in the “Making Money – Investors Corner” section of Investor’s Business Daily (IBD) written by Paul Whitfield, caught my attention. The article was about breakaway gaps as a bullish form of action. Whitfield illustrated several examples where stocks with price surges of 10% in a day often had very nice price appreciation gains several months in the future. The concept used in this type of stock selection depends on the positive event having some lasting power and traction. It uses the concept of buying high on positive news and selling higher. Articles in IBD often advocate this technique. This is the opposite of the buy low / sell high approach so often talked about by swing traders and other technical analyst.

Using the PowerOptions screening tool, we developed a set of screening parameters to find these potential opportunities. When these parameters were applied to our historical database, we were able to discover the opportunities as outlined in the article. However, these selections were not isolated, as there were other stocks that also met the screening criteria. Some of these stock selections were also very successful. In our screening efforts there were also some selections that were unsuccessful, similar to those mentioned in the Whitfield article. Whitfield did not specifically mention an exit strategy or a stop loss strategy. IBD often supports the idea of exiting if a stock drops in price by 8% from the initial purchase price of an investment. This is one way to limit losses and another way that we favor is to exit if the stock price falls below the 25 or 50 day moving average of the stock price.

The screening parameters used in our analysis were for the purchase of long calls using some of the key parameters mentioned in the Whitfield article:

% Stock Price > 10% (large price change in one day)

% Stock Volume > 200% (price change supported by large volume)

% Option Volume > 200% (option volume also increased)

Stock price > 20 Day Moving Average (stock in an uptrend)

% Earnings per share growth > 10%

Calls with expirations between 60 and 245 days out in time

Delta between .4 and .8 (calls at or slightly in the money)

Implied Volatility > .3

This screen found the stocks mentioned in the article and resulted in some very nice back testing gains of 40%+ as outlined by Whitfield. In our analysis PowerOptions proved to be a very powerful tool for finding the kinds of opportunities as outlined by Whitfield.

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[tags] IBD, Paul Whitfield, Option Volume, Delta, Implied Volatility [/tags]