Professional Documents
Culture Documents
4. Gap Closer 16
TRADING Strategies
FIGURE 2A MORNING UP-GAP TIME MARKERS FIGURE 2B MORNING DOWN-GAP TIME MARKERS
The primary time “milestones” in early trading show the The time markers for the typical down gap are the same
retracement to the previous close typically maximizes as those for up gaps.
around 9:53 a.m.
Morning bottom
Morning open — down gap on average
9:36 a.m. EST
One way to enter a trade is to wait for two consecutive bars that close lower than The pattern entry approach waits
they open (in the case of a downward reversal and potential short trade), with the for the market to reverse toward the
second bar also having a lower low than the first bar previous closing price before enter-
ing the trade. The trade is taken only
88.97 after two complete one-minute bars
S&P 500 index-tracking stock (SPY), one-minute in the direction of the reversal (i.e.,
88.92
88.88 bars with closes below their opens,
88.84 and the second bar with a lower low
88.80 than the previous bar, if the reversal
88.76
direction is down), as shown in
88.72
88.68 Figure 3). The advantage of this
Pattern entry: 88.64 approach is that by waiting for the
88.60 market to confirm the reversal prior
consecutive bearish
88.56 to entry, the trader avoids entering a
one-minute bars in the
88.52
direction of the reversal. losing position on days when the
88.48
88.44 market keeps running in the direc-
88.40 tion of the opening gap. The disad-
88.36 vantage is that the trader is always
88.32 late getting into the market and may
88.28
miss significant profits as a result.
88.24
88.20 The staggered entry combines the
88.16 first two approaches by breaking
88.12 the entry into two equal halves. The
88.08 first half of the trade is placed at 9:31
88.04
88.01
a.m. and the second half of the trade
1/22 15:42 15:46 15:50 15:54 15:58 16:02 16:06 16:10 16:14 16:18 16:22 16:26 1/23 9:32 9:36
is entered after two bearish one-
Source: Great-Trade by Protrader minute bars in the direction of the
reversal. This way, if the market
There are two qualifications for the open just above established support. reverses quickly, the trader has a
behavior of the futures in pre-market Both indices and stocks exhibit the partial position already in the market.
trading. First, all three index futures con- morning gap characteristics outlined However, if the market runs in the direc-
tracts (S&P, Nasdaq 100 and Dow) must here. Index-tracking stocks such as tion of the open, only half the trade is
trade consistently in the same direction QQQ, DIA, or SPY are good vehicles for exposed.
during the pre-market. For example, if trading the MGR strategy because, not
the Dow futures are down 35 points at 8 being subject to the up tick rule, they are Stop placement
a.m. and rally to trade up 20 points by 9 easier to sell short than individual equi- Every trader’s primary focus should be
a.m., they have changed from implying a ties. For these reasons, it is recommend- controlling risk and losses. Most traders
down opening to implying an up open- ed that you concentrate on the three are quick to take a small profit when the
ing. This kind of behavior should not be major index-tracking stocks when trad- market is willing to give a larger profit,
traded. Similarly, if one contract is up ing the MGR strategy. while at the same time they expose them-
and the other is down (e.g., the Nasdaq is selves to too much initial risk and are
up 5 and the Dow Jones is down 15), it is Trade entry slow to take losses. The following guide-
not a good day to use the MGR strategy. The average reversal start time is 9:36 lines are designed to let the market con-
Second, because a very narrow gap a.m., which means the trade-entry win- trol your profit while you control your
reduces profit potential, gaps in the dow is generally from 9:30 to 9:42 a.m. If risk.
futures contracts must be in excess of 5 a position has not been initiated by 9:42 The strategy uses three kinds of stop-
points for the S&P 500 futures, 10 points a.m., no trade is taken for the day. Three loss orders, the sizes of which are
for the Nasdaq 100 futures and 20 points entry techniques can be used with the intended for SPY, DIA and QQQ. The
for the Dow Jones futures. MGR strategy: time entry, pattern entry first type is the “high-low” stop. The
and staggered entry. primary risk in an MGR trade is the
Other factors A time entry consists of “playing the market will continue to run in the direc-
In addition to watching pre-market trad- averages” by entering a trade at 9:36 a.m., tion of the gap. Therefore, if the index-
ing activity, evaluate the support and regardless of what the market is doing at tracking stock trades 15 cents above the
resistance in the market you intend to the time. This approach has the advantage highest high of the morning (for up
trade. Be aware of the projected opening of being easy to execute, but it also runs gaps) or below the lowest low of the
price of the security relative to any sig- the risk of putting you immediately on the morning (for down gaps) after 9:45 a.m.,
nificant support or resistance levels. losing side of the market. Despite these the position should be closed. This is the
Often a market that is gapping up will disadvantages, a trader without a real- worst-case scenario and will yield the
open just under an established resistance time trading setup system may prefer this strategy’s largest losses.
level; a market gapping lower might method because of its simplicity. The second stop-loss is a trailing stop
When buying interest exceeds selling ket opens), market makers have an
interest, the gap will obviously be to the incentive to open a stock at extreme lev-
upside and vice versa. However, what is els directly correlated to the imbalance.
BY DAVID S. NASSAR not known is the price level at which the This simply means that if an imbalance
stock will open, and the precise risks is on the demand side, and a given stock
associated with being long or short in a is going to open strong, market makers
particular situation. will open it as high as they can, taking
Until recently, these price levels were the opposite side of the trade on open
often determined exclusively by large buy orders.
I
“off-floor” markets, such as Instinet, an Because most members of the public
institutional trading network that was trade only the long side of the market,
the first outside-market-hours trading many unsuspecting amateurs buy into
n today’s markets, many stocks medium. Today, with the advent of gap-up openings at what often will be
can have large supply-demand many other Electronic Communications the high price of the day. As a result, it is
imbalances at the opening bell. Networks (ECNs), there are many more worthwhile to explore the possibility of
Often, these imbalances result in retail traders active in pre- and post- trading situations when a gap will not
what are known as gaps, when the open- market trading. However, even though hold (reverses), rather than those
ing price is higher or lower than the pre- the public has access to the pre-market, instances when the stock follows
ceding close. the levels that trade pre-market are still through with a move in the same direc-
News, in various forms, is generally mostly influenced by market makers tion. Whether the stock reverses and
the catalyst for gap openings. The most who bid or offer stock at price levels closes the gap or follows through in the
common type is macroeconomic news away from the previous day’s close same direction, this move is perhaps the
such as FOMC meetings, the release of when imbalances appear in their auto- strongest indication of what the trend
economic indicators such as unemploy- mated systems. will be for the stock shortly after the gap
ment or the Consumer Price Index (CPI), Because many of these imbalanced opening. In the example of bullish gaps,
or stock-specific news such as earnings orders are “market on open orders” stocks that fail to meet new highs from
surprises or analyst upgrades or down- (meaning they are to be executed at the the opening levels will have a greater
grades. “best” available price as soon as the mar- likelihood to retrace and lose much of
Leading up to the earnings release on Oct. 27, shares of American Power Conversion (APCC) traded from 18 to 22 in
five days. The earnings didn’t live up to expectations and the stock gapped nearly seven points lower the following day.
21
20
19
18
17
16
15
14
13 1⁄16
Volume
1,000,000
500,000
255,300
0
11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11
10/20 Friday 10/23 Monday 10/24 Tuesday 10/25 Wednesday 10/26 Thursday 10/27 Friday 10/30 Monday
motion because of unforeseeable news is ments. This is because most positive earn- expectations.
generally not predictable. However, the ings expectations are built into the stock Short squeezes and profit taking.
gaps that may follow can occur for some price in the days prior to the report. For Short squeezes and profit taking are the
of the following reasons: this reason, stocks have a greater propen- most common reasons stocks will tend to
• Additional news, such as earnings sity to fall when companies merely meet build above-average volume into the
releases. expectations. close and cause what is called a “hook”
• Short squeezes and profit taking When expectations are missed, the close.
(“hook” closes). downside bias is dramatic. Therefore, In a short squeeze, a stock is in a
• S&P 500 futures volatility. you should rarely take an overnight downtrend and market makers suspect
These different factors can provide position in a company that is reporting there may be many short sellers in the
various signals that offer opportunities earnings after the close. If you do, your market. The squeeze and the hook occur
for gap trades. natural bias should be to trade the short when the professionals begin to buy the
Earnings. Earnings are perhaps the side — especially in this market environ- stock rapidly into the close, causing price
most significant factor regarding gap ment, where good earnings are often no to rise swiftly and forcing the short sell-
trades, because they have such a sub- match for inflationary pressure, rising ers to cover in a panic. Profit taking gen-
stantial impact on both stocks and sec- interest rates and oil prices. erally occurs when a stock is in a rising
tors. Because so many stocks have an trend but shows a weak close accompa-
The market is far more unforgiving of upside bias in the days prior to an earn- nied by high volume. At this point,
missed earnings than it is rewarding to ings report, it is best to sell into the news traders with long positions begin to sell
earnings that meet estimates. Many com- if you’re long the stock, and wait for the the stock to take a profit. Figure 3 shows
panies meet expectations and still get outcome. Figure 2 is an example of what an example of a short squeeze, while
hammered the day after their announce- companies experience when they miss Figure 4 is an example of a hook formed
On Oct. 26, Amgen (AMGN) closed the day near its high on a sudden spurt of buying that was likely the result of a short
squeeze. A look at the intraday chart reveals the stock was in a downtrend, with the previous support level at 69 1⁄2
becoming resistance.
70
68
66
64
62
60
59 1⁄8
1,200,000
Volume 1,057,900
1,000,000
800,000
600,000
400,000
200,000
0
12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10
10/25 Wednesday 10/26 Thursday 10/27 Friday
Source: QCharts by Quote.com
during profit taking. hold a losing position overnight, hoping all other questions and factors can be
If you’re not in a profitable situation the stock will “come back.” That is noth- answered favorably, you could keep
from day trading the stock, you should ing but gambling. your long position overnight.
not take the overnight gap trade. It is S&P 500 futures. S&P 500 futures are The point is you must have clarity and
best to stand aside and trade the open an important consideration when taking confirmation on all levels when taking a
the following day, after the stock gaps an overnight gap trade. You should look position overnight. Still, the most signif-
open — if it does. If you had a profitable at the correlation between the futures icant piece of information comes from
day-trading session, you can take the market and the index in relation to the the stock itself and how it behaved while
overnight position if you think the risk- gap-trading plan you have in mind. If you where trading and watching it in the
reward relationship is satisfactory. the futures are moving decisively higher days prior to the anticipated gap.
Remember, when going after an going into the close, and you have other Without this information, you will not
overnight position, it must always be independent reasons for the stock in be able to make a decision whether to
with purpose and confidence. Never question to gap higher the next day, and take a gap trade or not.
Gap trading is a risky business, and
the professionals who quote stocks up or
The first gap that sets the stock down prior to the open have a vested
interest in doing so. If you were a market
in motion because of unforeseeable news maker who made your living buying and
selling stocks from the public while pro-
viding liquidity to the market, where
is generally not predictable. would you open a stock with poor news
knowing you were to receive market on
54
52
50
48
46
44
42
Volume 200,000
150,000
100,000
50,000
8,200
14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12
10/27 Friday 10/30 Monday 10/31 Tuesday
Source: QCharts by Quote.com
open orders? You would open it as low as stock to buyers at what would be a sig- By contrast, if the stock continues to fol-
possible, where you felt the stock was nificant resistance level. This is referred low-through in the direction of the gap, it’s
well supported. This is known (from the to as “selling strength.” a strong indication that the trend will con-
market maker’s perspective) as “buying This is why gaps have a greater pro- tinue.
weakness.” pensity to close immediately after the Remember, however, that while these
Conversely, with strong news, know- open: After the initial panic selling or rules are good to use as a guide, they
ing you would be selling at the open, mania buying has been gobbled up by the should not be traded with indiscretion.
where would you open the stock? The market maker or specialist, a vacuum There are many factors that impact any
higher the better, so that you could short often develops and the stock will reverse. individual gap-trading situation. Ý
BY JOHN CARTER those in “multi-item” instruments such because of the diversity of their compo-
as stock indices because a news item will nent stocks. Both indices represent collec-
O
control the entire market instead of just a tions of stocks from different industries
portion of it. Earnings announcements, that are more likely to react independent-
corporate scandals and other company- ly to news events. In the technology-
pening price gaps — the specific events can create gaps in a com- heavy Nasdaq, opening price gaps can
distance between the reg- ponent stock’s chart that never get filled. take longer to fill because the majority of
ular-session opening price Because of the unpredictable nature of the stocks will react similarly to news.
and the previous day’s various events that can impact the price The key to trading opening gaps is
closing price — are stomach-churning of an individual stock, they make poor being able to predict the likelihood a
events when the market makes a big candidates for the opening-gap trade. particular gap will be filled. Dissecting
move against you, but they represent In contrast, stock index futures such as the market conditions that produce a
low-risk trade opportunities if you know the E-mini S&P (ES) or the mini-sized gap is as important as analyzing a gap
which gaps are likely to be followed by Dow (YM) are better candidates for itself. For example, an opening gap fol-
predictable patterns. opening-gap plays because they consist lowing high pre-market cash trading
In terms of the price behavior that fol- of multiple components that respond dif- volume can take weeks to get filled
lows opening gaps, not all markets are ferently to news. For example, although a because high volume increases the odds
created equal. Gaps in individual stocks stock index futures contract may gap up the market will continue to move in the
and commodities do not act the same as on a news item, there will be individual direction of the gap.
stocks within the index that will either Some of the biggest gaps are caused
TABLE 1 FILLING THE OPENING ignore the news or sell off. This weighs by major news events, such as the out-
GAP: RAW DATA the index down and creates a trade break of a war, but gaps caused by minor
opportunity as the market fills the gap. news items are much more common.
Between Jan. 15, 2002, through Generally, such gaps are smaller, fill
February 2004 (528 occurrences), The best markets for gap plays quickly (see Table 1) and can be “faded”
an average of 76 percent of all The S&P 500 and the Dow are the best (the act of trading against the direction
opening gaps closed at some point markets to trade the opening gap of the gap) more effectively. Let’s look at
during the same day. This is the
breakdown by day of week. Adding
the pre-market volume filter TABLE 2 TRADE MANAGEMENT GUIDELINES
increased the percentages. The higher the volume, the greater the likelihood the market will continue
in the direction of the opening gap. As a result, no trade is taken when vol -
Percentage of ume is above 70,000.
Day gaps filled
Pre-market volume
Monday 65% in key stocks Position size Trade target
Tuesday 77% Less than 30,000 Full size Exit entire position at gap fill
Wednesday 79% Between 2/3 size Exit half at 50 percent of gap
Thursday 82% 30,000 and 70,000 fill, half at gap fill
FIGURE 2 THE DAY AFTER thousand dollars, this trading plan con-
trols risk by limiting exposure relative
One day after the trade setup shown in Figure 1, the mini Dow contract to the amount of available capital.
opened lower, setting up a long trade. Use a 1:1.5 reward/risk ratio (risking
9,800 1.5 points to make 1 point) for gap
Mini Dow futures (YM), five minute trades that are less than 40 mini Dow
points or 4 E-mini S&P points. For gaps
9,790 larger than these, use a 1:1 reward/risk
Gap filled for a 61-point ratio. In the case of Figure 1, we would
gain, or $305 per contract. 9,780 risk 47 points to make 47 points. If the
gap had been 30 points, we would risk
9,770 45 points.
Some traders might question an
approach that risks more than the
9,760
potential profit. Most beginning traders
are taught to use a 3:1 reward/risk
9,750 ratio, risking 1 point to gain 3. They
inevitably wonder why they are repeat-
9,740 edly stopped out just before the market
turns. In general, wider stops produce
more winning trades; the key is to trade
9,730
only those setups with a better than 80-
percent chance of winning.
9,720 The market sold off immediately
after the bell, filling the opening gap
9,710 within an hour. Ironically, the next day
IBM came out with a disappointing
earnings report, knocking the market
10/16/03 9,700
down on the open. Figure 2 shows the
15:00 9:00 10:00 11:00 12:00 13:00 14:00 resulting buy setup had just a small
Source: eSignal open loss at one point, although many
traders might have been stopped out
FIGURE 3 EMOTIONS TRIGGER GAP on the pullback around 11 a.m. ET.
However, keep in mind the strategy
The E-mini S&P futures made a downside opening gap on Aug. 2, 2004, on terrorist is to maintain a reward/risk ratio of
threats. The market spent most of the day filling the gap. 1:1, not to tighten your stop when
the market moves in your favor. If
E-mini S&P 500 continuous contract (ES), five minute 1,106 the stop had been hit, the loss would
have been approximately $305 per
1,105 contract ($2,745 for the nine-contract
Close on 7/30/04:
1,103.75 full position), not including slippage
1,104 and commissions. This loss is rea-
sonable because of the 80-percent
1,103 success rate of the setup.
Using a tighter initial stop or trail-
1,102
ing stop would have turned this
position into a losing trade or, at
1,101
best, a breakeven trade. Using the
1,100
risk parameters designed for this
trade setup allowed the position to
1,099 remain open until the gap was filled
for a gain of 61 points. As a rule,
1,098 using a trailing stop will negatively
affect the gap trade’s win/loss ratio.
1,097 When the trade is executed, the
Open on 8/2/04: best thing a trader can do is to walk
1,097.00 1,096 away and let the orders do their
14:45 15:0515:25 15:45 8/2 10:00 10:2010:4011:00 11:20 11:4012:00 12:20 12:40 13:00 13:2013:40
work. This is the difference between
professionals and amateurs:
Source: TradeStation Professionals won’t second-guess a
120,000
100,000
System concept: Most traders are familiar
with the technical analysis axiom, “All gaps 90,000
Drawdown Avg. loss (losers) %: -31.80 Weekly 0.03% 0.16 6.56% -12.50% 49.23% 9 17
Monthly 0.15% 0.16 13.54% -9.68% 47.90% 5 6
Max. DD (%): -24.75 Avg. hold time (losers): 348.50
Quarterly 0.43% 0.15 16.34% -14.11% 53.66% 3 3
Longest flat days: 465 Max. consec. win/loss: 38/4
Annually 1.60% 0.22 10.73% -12.90% 60.00% 4 1
LEGEND: Net profit — profit at end of test period, less commission •
Exposure — the area of the equity curve exposed to long or short positions, as
LEGEND: Avg. return — the average percentage for the period • Sharpe ratio
opposed to cash • Profit factor — gross profit divided by gross loss • Payoff
— average return divided by standard deviation of returns (annualized) •
ratio — average profit of winning trades divided by average loss of losing
Best return — best return for the period • Worst return — worst return for
trades • Recovery factor — net profit divided by max. drawdown • Max DD
the period • % Profitable periods — the percentage of periods that were prof -
(%) — largest percentage decline in equity • Longest flat days — longest
itable • Max. consec. profitable — the largest number of consecutive prof -
period, in days, the system is between two equity highs • No. trades — num -
itable periods • Max. consec. unprofitable — the largest number of consec -
ber of trades generated by the system • Win/Loss (%) — the percentage of
utive unprofitable periods
trades that were profitable • Avg. profit — the average profit for all trades •
Avg. hold time — the average holding period for all trades • Avg. profit
(winners) — the average profit for winning trades • Avg. hold time (win- Trading System Lab strategies are tested on a portfolio basis (unless
ners) — the average holding time for winning trades • Avg. loss (losers) — otherwise noted) using Wealth-Lab Inc.’s testing platform.
the average loss for losing trades • Avg. hold time (losers) — the average If you have a system you’d like to see tested, please send the trad-
holding time for losing trades • Max. consec. win/loss — the maximum ing and money-management rules to editorial@activetradermag.com.
number of consecutive winning and losing trades
Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or
promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not
guarantee future results; historical testing may not reflect a system’s behavior in real-time trading.
Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or
promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not
guarantee future results; historical testing may not reflect a system’s behavior in real-time trading.