Many technical traders put a lot of stock into gaps on the chart. Gaps are formed when the market is closed and the bid/ask changes by the time it re-opens. These types of gaps occur on all manner of charts: equities, indexes, index futures, commodity futures, forex, you name it. Traders fall into three basic categories in regards to these types of gaps:
- They believe they matter and hold fast to them as if they are some deeply held religious belief. “The gap will always be filled” they contend.
- They believe they are irrelevant but acknowledge that enough other traders hold onto (1) and hence play along here and there.
- They believe they are stupid.
I am mostly in camp (3) but will go along for (2) now and then if the gap is large enough, or if it has just occurred, and a retrace seems likely.
Where I am in camp (1) is with commodity futures and for a very specific kind of gap, called the rollover gap. A rollover gap occurs when one futures contract ends and the price of the next futures contract is different. For example, natural gas’s June 2020 contract ended on May 27th at 1.721. The July contract was trading at 1.876 at the time. Why does this gap matter, and how is it “filled”?
Why commodity rollover gaps matter
The gap in contracts matters because it represent an arbitrage opportunity in the real world. You can buy the contract which obligates you to take physical delivery of the commodity and then you can store it for a month. You can then sell the next month’s futures contract (assuming it is higher), and if the cost of storage is below the size of the gap then you can be guaranteed a profit.
Lets return to our natural gas example. The June contract closed at 1.721 and the July contract was was trading at 1.876 at the time. You could buy the June contract, and take physical delivery of the gas. The storage fee for natural gas varies but let’s say it is 0.05 cents, which is about 2X the re-injection cost when there is ample storage. Simultaneously sell the July contract. You’ve now paid $1.721 for gas and be assured that you will be able to sell it in a month for $1.876. It will cost you $0.05 to store it for that amount of time, but is a guaranteed $0.105 profit. Who doesn’t like free money?
So what happens in the financial world because of this? The person who takes delivery of the gas and shorts the next month’s contract creates downward pricing pressure on the active contract. This downward pricing pressure is noticed in the market and FOMO kicks in. Traders pile in and the price goes down and the gap is closed, and can often times sink below the prior month’s closing price.
What happens if the front month is less expensive than the back month? First of all there is very little incentive for this to happen. The back month price generally collapses because the simple arbitrage trade described above doesn’t work. Who would take delivery of something they can’t be assured to sell at a profit? Commodity futures are monthly so it’ is also possible to do the same trade but shorting a different month further out. Storage costs rise, but it may still be profitable. There are traders that just play the spread between months so this downward pressure on future months is noticed and effectively shortens the financial gap between as yet unsettled futures contracts.
What about spot price?
Futures contracts are just that, a contract to buy or sell something at a specified time in the future. There is a price for that something right now. That price is called the spot price. On contract closing the spot price should converge to the futures price, but it doesn’t have to if some extreme situation is occurring. The reason they should converge is again arbitrage. Traders can buy or sell the futures contract if there’s a difference between spot and contract price. This financial movement pushes the contract price towards the actual spot price at the time of contract termination. But in extreme situations, lack of liquidity, market shock, extreme storage or transportation fees, this financial movement may not occur. Witness the implosion of oil prices in 2020 when storage space essentially filled up.
Can the gap be closed by the spot price movement? The short answer is yes and even if it does, it doesn’t always matter. Let’s return to our natural gas example. On May 27th the spot price was $1.78. Here’s an example where spot and futures contract price did not converge. Let’s recap, contract closed at $1.721, spot price $1.78 and front month price $1.876. In this case you don’t even have to pay a storage fee, just take delivery and immediately sell it for the spot price — quick profit, and the gap partly closed. The person who takes delivery of the gas still shorts the front month contract. But then if the spot price moves up to meet the front month price, you just sell the gas on the spot market and close out the front month contract. When this happens we say the gap was “closed from below”.
Does closing from below matter, however? Here we return to gaps on equity / index charts. Some traders think those gaps matter and because the gap will still exist on the futures chart they will think it still matters. Just the fact that enough traders think it matters can make it matter (see 2 above).
When does the gap occur? This is an interesting question. In the real world the gap occurs at the time of contract closing. But in the financial world different trading platforms “roll” their continuous chart over at a different times. Some even do crazy averaging between contract prices. This means different traders will see slightly different gaps. The gaps may not matter in the real world, but again, because of item 2 above, if enough people believe they matter, then it can matter.
Gaps on financial instruments have no real meaning beyond the fact that if enough traders think they matter, then they start to matter; gaps fill because price moves not because they have to. The rollover gap in commodity futures does matter because there is a real physical arbitrage trade that can be made that guarantees profit.