We’ve been cheering the markets to go to zero for a while now, since trend followers (the bread and butter of managed futures) are largely in short positions right now.  And thus didn’t look to favorably upon the Spanish bailout news over the weekend which saw S&P futures “gap up” over 20 points (about 1.5%) as we were going to bed last night.

Fortunately, the knee jerk reaction to the news wasn’t a lasting rally, with most markets quickly “filling the gap.”

What’s all this gap talk? When markets “jump” from one price to another, without trading at any of the prices in between, it leaves a gap in the price chart. Wikipedia actually does a pretty good job of explaining it. Now, there’s two things that can happen with a gap. Prices can keep going in the direction of the gap move, or they can reverse course and “fill the gap.”  The common wisdom of traders is that all gaps eventually will be “filled.”  Just be careful with that “eventually” part – it can be painful.

The purely technical traders may argue that gaps get filled because there must be a print at each price level or something similar, but the basic thought is that when prices jump that quickly, it probably represents a case of either irrational exuberance or panic. Once investors regain their senses the markets will retrace and trade in the range that was skipped over. A gap trade, then, is like a confrontation between fundamental and technical traders. Fundamental traders create the gap, expecting the news to drive prices, while technical traders often take the opposite position. In fact, many trading systems have gap targets coded in, looking for such price action as a signal to get in on the trade.

In this case, Euro news exhaustion may have been working in our favor. We’ve complained in the past about trading in an environment where every bit of news out of Europe sends the markets scurrying up or down, but the rally following the announcement of a bailout for Spain turned out to be small, and relatively brief. By 10am the excitement had worn off, the rally had reversed, and the gap had been filled. This doesn’t mean we won’t still see the dreaded June reversal, but today’s “fill the gap” move has given us a little more breathing room.