We will probably jinx ourselves by writing this post, but here we go.  When trading spreads we often worry about one side gapping against us, especially the short side.  That said it seems more often than not we benefit from gaps or sharp stock moves in our spread book.  We began thinking about this Friday afternoon when a stock we were short, Regeneron Pharmaceuticals ($REGN), was halted pending news.  The news was positive, but the stock opened only about 4% higher and eventually traded below yesterday’s close.  I can think of a few examples over the past two months in which we benefitted from a plus or minus 10% move in a stock, including yesterday when Darling International ($DAR), a short of ours, was at one point down 15% on news that the Senate approved an amendment ending ethanol subsidies.

Assuming I don’t have selective memory and I have observed enough data, why is it that we seem to win more than lose from gaps?  I think it has to do with the nature of our methodology.  We are trading spreads based on statistics.  We enter a trade when the spread is a certain number of standard deviations from the mean.  So we are often buying stocks that are trading at historically low values, or selling stocks that are trading at historically high values, or some combination of the two.  So our longs don’t have a lot of room left to fall and our shorts don’t have a lot of room left to soar.  In a book of 50 plus spreads we occasionally take a hit, but so far the gaps have been in our favor.

Written by Norm Winer. Follow me on Twitter and StockTwits.