Gap Trading Techniques
1. Morning Reversal Strategy
2
2. Trading The Overnight Gap
6
3. Trading The Opening Gap
12
4. Gap Closer
16
F
inding a strategy that back-tests successfully is rare; find-ing one that is reproducible in live trading is rarer still. The following intraday strategy — the Morning Gap Reversal (MGR) — capital-izes on the major indices’ tendency to retrace toward the prior day’s close each morning. It has a high winning perc e n t a g e tested in both bull and bear conditions — an important characteristic for any short-term strategy — and it is easy to execute.Each morning the opening price of an index or stock is higher or lower than the
prior day’s closing price. This price change is called the morning gap if it is above the previous day’s high (an “up gap”) or below the previous day’s low (a “down gap”). However, for simplicity, we will use “gap” to refer to the distance between the previous close and current open, regardless of whether or not the open falls within the previous day’s range (see Figure 1).
First, we will analyze the behavior of morning gaps to determine if they pro-vide a logical basis for a trading strategy.
Morning gap statistics
Statistically, price has a very high likeli-hood of filling between 50 and 100 per-cent of the gap between yesterd a y ’ s close and today’s open during the trad-ing day. Usually, a reversal that fills (or partially fills) the gap will occur within the first 30 minutes of trading (by 10 a.m. ET).
T h ree years of back-testing fro m January 1999 to January 2003 on the Dow Jones Industrial Average (INDU), S&P 500 (SPX) and Nasdaq 100 (NDX) indices was conducted to verify the sta-tistical reliability of the basis for the MGR strategy. The analysis was divided into three parts: first, deter-mining the frequency and extent of morning gap reversals; second, find-ing out how quickly mornfind-ing gaps reversed; and third, identifying important “time markers” within the reversal period.
Table 1 summarizes the first part of the analysis. The columns show different gap sizes, from 1 to 3 per-cent (positive or negative). The rows show what percentage of the gaps were filled, and the cells show how often they were filled (at some point during the trading session).
The table shows 85 percent of the gaps between zero and 1 percent in size (positive or negative) closed at least halfway, and 78 percent of the gaps closed between 90 and 100 per-cent.
Although slightly less re l i a b l e , gaps between 1 and 2 percent (posi-tive or nega(posi-tive) showed a similar tendency to be partially retraced or
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S&P 500 index-tracking stock (SPY), one-minute
In the first half-hour of the trading session, the market will frequently retrace in the direction of the previous day’s close.
FIGURE 1 MORNING “GAPS”: REVERTING TO THE CLOSE
Source: Great-Trade by Protrader
8 8 . 9 7 8 8 . 9 2 8 8 . 8 8 8 8 . 8 4 8 8 . 8 0 8 8 . 7 6 8 8 . 7 2 8 8 . 6 8 8 8 . 6 4 8 8 . 6 0 8 8 . 5 6 8 8 . 5 2 8 8 . 4 8 8 8 . 4 4 8 8 . 4 0 8 8 . 3 6 8 8 . 3 2 8 8 . 2 8 8 8 . 2 4 8 8 . 2 0 8 8 . 1 6 8 8 . 1 2 8 8 . 0 8 8 8 . 0 4 8 8 . 0 1 1/22 15:40 15:45 15:50 15:55 1/23 9:35 9:40 9:45 9:50 9:55 10:00 10:05 10:10
Market open price
Gap up
Prior day close Reversal
M o r n i n g
R E V E R S A L
s t r a t e g y
TRADING Strategies
BY BRYAN C. BABCOCK AND ARTHUR AGNELLI
Historical tests reveal the tendency of the major stock indices to revert to the
previous day’s closing price in the early minutes of the trading session. This
strategy takes its cue from that bit of market behavior.
filled. These gaps retraced by at least half 78 percent of the time and retraced between 90 and 100 percent 62 percent of the mornings studied. Gaps in the 2- to 3 - p e rcent range were somewhat less likely to be filled.
Only 14 percent of the gaps (in the “Overall” column) closed between zero and 9 percent, which includes those mornings when price immediately moved in the opposite direction of the gap closure, creating what is known as a “gap and run.”
The second part of the analysis e x p l o red how quickly gaps re v e r s e d . The gaps typically closed half way (50 percent) by 9:55 a.m. Of the gaps that closed completely, 67 percent of them did so in the first 30 minutes of the trad-ing session, and 86 percent closed by the end of the first hour of trading (10:30 a.m. ET). The likelihood of additional closure declined substantially after the first hour of trading. Gaps that were still open after 60 minutes closed only 4.5 percent of the time. Also, the success rate diminished on days when economic news was released 30 minutes after the market open, at 10 a.m. ET.
The third portion of the analysis iden-tified important time markers during the g a p - reversal period. Figure 2 (below) shows the typical time markers for gap reversals. Just after the open, the major indices tended to continue to move in the
d i rection of the opening price for the first one to 10
minutes. A f t e r
this initial rally (or sell-off), the
market turned
and began to close the morn-ing gap. This reversal, on aver-age, began six minutes after the open, at 9:36 a.m. E T. The typical reversal was maximized at 9:53 a.m. ET. An appro x i-mately
four-minute countertrend move (or “jig,” which often fakes out traders into cover-ing positions early) typically occurre d a round 9:42 a.m. and lasted until appro x-imately 9:47 a.m.
Before the bell:
Pre-market review process
The first step in trading the MGR is antic-ipating the direction of the opening move. Usually two hours before the mar-ket opens a reliable gap can be identified by checking the pre-market stock index f u t u res quotes on CNBC or Bloomberg T V. (Minute by minute pre-market index
f u t u res quotes are also available thro u g h the Chicago Mercantile Exchange We b site, w w w.cme.com.) Whether these con-tracts are trading up or down in the early morning can give you an indication of the possible direction of the stock market o p e n .
Second, make note of how the futures are affected in the pre-market by any economic reports released at 8:30 a.m. E T. This will indicate whether the futures are strengthening or weakening in pre-market trading. Make a final check of the futures at 9:10 a.m. (20 min-utes prior to the market open).
ACTIVE TRADER • May 2003 • www.activetradermag.com 3
Morning open — up gap
Morning peak on average 9:36 a.m. EST
The primary time “milestones” in early trading show the retracement to the previous close typically maximizes around 9:53 a.m.
FIGURE 2A MORNING UP-GAP TIME MARKERS
The time markers for the typical down gap are the same as those for up gaps.
FIGURE 2B MORNING DOWN-GAP TIME MARKERS
Prior day closing price Prior day
closing price
Morning open — down gap
Trade is maximized 9:53 a.m.
Trade is maximized
9:53 a.m. Price “jig” — usually 9:42-9:47 a.m. Price “jig” — usually
9:42-9:47 a.m.
Morning bottom on average 9:36 a.m. EST Gap size
% of gap closed +/-1% +/-1 to +/-2% +/-2 to +/-3% Overall
0-9 12 8 19 14 10-19 0 2 5 2 20-29 1 6 5 2 30-39 1 4 6 2 40-49 1 2 5 1 50-59 2 5 2 1 60-69 1 7 4 2 70-79 2 1 4 2 80-89 2 3 2 2 90-100 78 62 48 72 50% 85 78 60 79
The columns show morning gaps of different sizes. The rows indicate how much of the gaps were filled.
T h e re are two qualifications for the behavior of the futures in pre - m a r k e t trading. First, all three index futures con-tracts (S&P, Nasdaq 100 and Dow) must trade consistently in the same dire c t i o n during the pre-market. For example, if the Dow futures are down 35 points at 8 a.m. and rally to trade up 20 points by 9 a.m., they have changed from implying a down opening to implying an up open-ing. This kind of behavior should not be traded. Similarly, if one contract is up and the other is down (e.g., the Nasdaq is up 5 and the Dow Jones is down 15), it is not a good day to use the MGR strategy. Second, because a very narrow gap reduces profit potential, gaps in the futures contracts must be in excess of 5 points for the S&P 500 futures, 10 points for the Nasdaq 100 futures and 20 points for the Dow Jones futures.
Other factors
In addition to watching pre-market trad-ing activity, evaluate the support and resistance in the market you intend to trade. Be aware of the projected opening price of the security relative to any sig-nificant support or resistance levels. Often a market that is gapping up will open just under an established resistance level; a market gapping lower might
open just above established support. Both indices and stocks exhibit the morning gap characteristics outlined h e re. Index-tracking stocks such as QQQ, DIA, or SPY are good vehicles for trading the MGR strategy because, not being subject to the up tick rule, they are easier to sell short than individual equi-ties. For these reasons, it is recommend-ed that you concentrate on the three major index-tracking stocks when trad-ing the MGR strategy.
Trade entry
The average reversal start time is 9:36 a.m., which means the trade-entry win-dow is generally from 9:30 to 9:42 a.m. If a position has not been initiated by 9:42 a.m., no trade is taken for the day. Three entry techniques can be used with the MGR strategy: time entry, pattern entry and staggered entry.
A time entry consists of “playing the averages” by entering a trade at 9:36 a.m., re g a rdless of what the market is doing at the time. This approach has the advantage of being easy to execute, but it also ru n s the risk of putting you immediately on the losing side of the market. Despite these disadvantages, a trader without a re a l -time trading setup system may prefer this method because of its simplicity.
The pattern entry approach waits for the market to reverse toward the p revious closing price before enter-ing the trade. The trade is taken only after two complete one-minute bars in the direction of the reversal (i.e., bars with closes below their opens, and the second bar with a lower low than the previous bar, if the re v e r s a l d i rection is down), as shown in F i g u re 3). The advantage of this a p p roach is that by waiting for the market to confirm the reversal prior to entry, the trader avoids entering a losing position on days when the market keeps running in the dire c-tion of the opening gap. The disad-vantage is that the trader is always late getting into the market and may miss significant profits as a result.
The staggered entry combines the first two approaches by bre a k i n g the entry into two equal halves. The first half of the trade is placed at 9:31 a.m. and the second half of the trade is entered after two bearish one-minute bars in the direction of the reversal. This way, if the market reverses quickly, the trader has a partial position already in the market. H o w e v e r, if the market runs in the dire c-tion of the open, only half the trade is exposed.
Stop placement
Every trader’s primary focus should be c o n t rolling risk and losses. Most traders a re quick to take a small profit when the market is willing to give a larger pro f i t , while at the same time they expose them-selves to too much initial risk and are slow to take losses. The following guide-lines are designed to let the market con-t rol your proficon-t while you concon-trol your risk.
The strategy uses three kinds of stop-loss orders, the sizes of which are intended for SPY, DIA and QQQ. The first type is the “high-low” stop. The primary risk in an MGR trade is the market will continue to run in the dire c-tion of the gap. There f o re, if the index-tracking stock trades 15 cents above the highest high of the morning (for up gaps) or below the lowest low of the morning (for down gaps) after 9:45 a.m., the position should be closed. This is the worst-case scenario and will yield the strategy’s largest losses.
The second stop-loss is a trailing stop
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One way to enter a trade is to wait for two consecutive bars that close lower than they open (in the case of a downward reversal and potential short trade), with the second bar also having a lower low than the first bar
FIGURE 3 PATTERN ENTRY
Source: Great-Trade by Protrader
8 8 . 9 7 8 8 . 9 2 8 8 . 8 8 8 8 . 8 4 8 8 . 8 0 8 8 . 7 6 8 8 . 7 2 8 8 . 6 8 8 8 . 6 4 8 8 . 6 0 8 8 . 5 6 8 8 . 5 2 8 8 . 4 8 8 8 . 4 4 8 8 . 4 0 8 8 . 3 6 8 8 . 3 2 8 8 . 2 8 8 8 . 2 4 8 8 . 2 0 8 8 . 1 6 8 8 . 1 2 8 8 . 0 8 8 8 . 0 4 8 8 . 0 1 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
S&P 500 index-tracking stock (SPY), one-minute
Pattern entry: consecutive bearish one-minute bars in the direction of the reversal.
ACTIVE TRADER • May 2003 • www.activetradermag.com 5
that requires evaluating where the trade is relative to the best price it has experienced up to that point. First, once a 25-cent profit has been reached, move the stop to breakeven. When a 35-cent profit is in place, trail the stop-loss 25 cents above the highest high (for a short trade) or below the lowest low (for a long trade) reached dur-ing the trade.
For example, if the position is up 35 cents and moves back to being up only 10 cents, exit the trade; if the position is up 50 cents and moves back to being up only 25 cents, exit the trade. This a p p roach continually moves the stop in the direction of the trade.
The third stop is the “time stop.” Because this strategy is most successful in the first 30 min-utes of trading (and because eco-nomic announcements often occur at 10 a.m. ET), the time stop liqui-dates any position that is still open at 9:55 a.m.. This allows the trader to take advantage of the most ben-eficial time period without exposing the trade to the volatility of adverse reac-tions to news.
In actual trading, the majority of los-ing trades are stopped out with a loss of 50 cents or less. In tests, a 50-cent absolute stop in the SPY and DIA w a s r a rely hit. The lower price of the QQQ made them even less susceptible to being hit; the typical maximum loss in the QQQ is closer to 30 cents than 50 cents.
Position sizing
Correct position sizing will enable you to focus on the strategy without being distracted by unnecessary anxiety. A
conservative money management
benchmark is to risk no more than 2 per-cent of account equity on a trade. This means a trading account of $25,000 could aff o rd to risk $500 per trade ($25,000 x .02 = $500). Because this strat-egy typically stops out a losing trade within 50 cents of the entry, it’s possible to trade up to 1,000 ($0.50 x 1,000 = $500) shares.
C a v e a t s
The stop-loss rules are structured to let the market determine how large the profit should become when the trade runs in the desired direction.
However, when the gap closes entire-ly before 9:55 a.m., half the position should be closed. (The prior day’s close is a natural resistance/support level; if it is penetrated, the possibility of a turn-around off that level emerges.) The sec-ond half of the position should be kept open in case the market continues to move profitably.
Finally, the “jig” mentioned in the sta-tistics section occurs quite fre q u e n t l y between 9:42 and 9:47 a.m. ET. Because this countertrend move can fool a trader into closing a position too quickly, try to avoid closing a position during this time frame. Stick to your original stop-loss levels.
Trade example
Figure 4 shows the Dow Jones Industrial Average tracking stock (DIA) opening higher (on Jan. 23, 2003) than the preced-ing close, settpreced-ing up a potential short sale.
Using the simplest entry approach, a short trade was entered at 9:37 a.m. ET at $83.74 (the market was already starting to retrace toward the previous closing price of $83.24). The initial stop-loss was placed at $84.07, which corresponds to the morning high plus 15 cents. (The chart also shows where the pattern entry
technique could have been used.) The market continued to move lower, first reaching the 25-cent profit level at approximately 9:41 a.m., at which point the stop is moved to breakeven. Next, DIA reaches the prior day’s closing price around 9:48 a.m. When this target was reached, 50 percent of the position was closed for a 50-cent profit.
F rom this point onward, the balance of the position would be exited with the 25-cent trailing stop or at 9:55 a.m., whichev-er comes first. In this case, the time stop was reached, closing the second half of the trade at $83.47 for a 27-cent profit. The trade’s total profit was just over 38 cents, taking into account the two exits.
Statistical foundation
and tight risk control
The MGR strategy is based on the favor-able statistical performance of early morning reversals back to the previous day’s closing price. It combines a high winning percentage with conservative risk management.
The strategy’s simplicity makes it easy to monitor and “paper-trade” in real-time, which lays the groundwork
for actual trading.
Ý
For information on the authors see p. 12. In this case, the entire morning gap was filled in the first 20 minutes of trading, at which point half the trade was liquidated and a 25-cent trailing stop was used to protect the remainder.
FIGURE 4 SHORT-TRADE EXAMPLE
Source: Great-Trade by Protrader
8 4 . 2 7 4 8 4 . 2 0 8 4 . 1 6 8 4 . 1 2 8 4 . 0 8 8 4 . 0 4 8 4 . 0 0 8 3 . 9 6 8 3 . 9 2 8 3 . 8 8 8 3 . 8 4 8 3 . 8 0 8 3 . 7 6 8 3 . 7 2 8 3 . 6 8 8 3 . 6 4 8 3 . 6 0 8 3 . 5 6 8 3 . 5 2 8 3 . 4 8 8 3 . 4 4 8 3 . 4 0 8 3 . 3 6 8 3 . 3 2 8 3 . 2 8 8 3 . 2 4 8 3 . 2 0 8 3 . 1 6 8 3 . 1 2 8 3 . 0 8 8 3 . 0 4 8 3 . 0 1 1/22 15:30 15:35 15:40 15:45 15:50 15:55 1/23 9:35 9:40 9:45 9:50 9:55 10:00
Dow Jones Industrial Average index-tracking stock (DIA), one-minute
Exit 50 percent of the position (at 83.24) when the entire morning gap is closed.
Exit remainder of position at 9:55 a.m ET
(83.47) Pattern entry
(Two consecutive one-minute bars in the direction of the reversal) Entry:
Price — 83.74 Time — 9:37 a.m. ET
Initial stop-loss is placed at the morning high plus 15 cents
I
n today’s markets, many stocks can have large supply-demand imbalances at the opening bell. Often, these imbalances result in what are known as gaps, when the open-ing price is higher or lower than the pre-ceding close.News, in various forms, is generally the catalyst for gap openings. The most common type is macroeconomic news such as FOMC meetings, the release of economic indicators such as unemploy-ment or the Consumer Price Index (CPI), or stock-specific news such as earnings surprises or analyst upgrades or down-grades.
When buying interest exceeds selling interest, the gap will obviously be to the upside and vice versa. However, what is not known is the price level at which the stock will open, and the precise risks associated with being long or short in a particular situation.
Until recently, these price levels were often determined exclusively by large “off-floor” markets, such as Instinet, an institutional trading network that was the first outside-market-hours trading medium. To d a y, with the advent of many other Electronic Communications Networks (ECNs), there are many more retail traders active in pre- and post-market trading. However, even though the public has access to the pre-market, the levels that trade pre-market are still mostly influenced by market makers who bid or offer stock at price levels away from the previous day’s close when imbalances appear in their auto-mated systems.
Because many of these imbalanced o rders are “market on open ord e r s ” (meaning they are to be executed at the “best” available price as soon as the
mar-ket opens), marmar-ket makers have an incentive to open a stock at extreme lev-els directly correlated to the imbalance. This simply means that if an imbalance is on the demand side, and a given stock is going to open strong, market makers will open it as high as they can, taking the opposite side of the trade on open buy orders.
Because most members of the public trade only the long side of the market, many unsuspecting amateurs buy into gap-up openings at what often will be the high price of the day. As a result, it is worthwhile to explore the possibility of trading situations when a gap will not hold (reverses), rather than those instances when the stock follows through with a move in the same direc-tion. Whether the stock reverses and closes the gap or follows through in the same direction, this move is perhaps the strongest indication of what the trend will be for the stock shortly after the gap opening. In the example of bullish gaps, stocks that fail to meet new highs from the opening levels will have a greater likelihood to retrace and lose much of
6 www.activetradermag.com • March 2001 • ACTIVE TRADER
Trading the overnight
G A P
With increasingly reactionary markets
comes the higher risk of opening gaps.
Learn how to spot the early warning signs
and how to take advantage of them.
The first clue that a stock is ripe for a gap opening
is an increase in volume over its normal daily average.
BY DAVID S. NASSAR
ACTIVE TRADER • March 2001 • www.activetradermag.com 7
the opening gap.
C o n v e r s e l y, stocks that re m a i n strong and trade to new highs after the opening gap will have a greater likeli-hood of following through and trend-ing higher. While this shouldn’t be interpreted too rigidly (there are other indicators to monitor, such as index strength and sector strength, etc.), it is the strongest single indication of how a stock will trade following a gap open-ing.
Regardless of whether gaps are to the upside or downside, it is important to study the impact they have on stocks. The following components and considerations are most important when trading gaps:
• Charged stocks/sectors; • Volume and volatility; • Chaos and over-activity; • High risk (elasticity).
Let’s look at each of these factors.
Where the action is:
Charged stocks and sectors
Once a sector is in the public eye, think of the component stocks as being pumped up or “charged.” When this occurs, the volume in the stock will increase, and there will be a tremen-dous swing in the trading range from one session to the next, either to the upside or downside. Before the open-ing bell, in the absence of actual trade a c t i v i t y, market makers will pre d i c t price pattern changes — either slightly before an event or immediately after one — and bid the stock higher or lower based on their predictions.
If a major stock within a sector experi-ences negative or positive news, it can charge an entire sector. Figure 1 shows Intel (INTC) gapping down after nega-tive news on inventories. The entire Philadelphia semi-conductor index (SOX) became charged and volatile
immediately after. As you can see from the chart, Intel did not hold its levels after the first gap and followed through by trending lower, as did the SOX index.
Early warning signs:
Volume and volatility
The first clue that a stock is ripe for a gap opening is an increase in volume over its normal daily average. Often, the volume
increase will occur before the news is known. This is an indication that news is leaking in the market and explains the cliché “stocks tell their own story” ahead of news. Remember, the biggest trading houses often have strong indications of sector and stock stre n g t h / w e a k n e s s b e f o re the media. There f o re, when increases in daily volume accompanied by directional bias are seen in the
Source: QCharts by Quote.com
Starting in September 2000, the uptrend in Intel (top chart) came to a halt, punctuated by a series of downside gaps. Typically viewed as a blue-chip stock free of extreme volatility, Intel became much more volatile after the first down gap; it became a "charged" stock that propelled the entire semiconductor sector lower (bottom chart).
FIGURE 1 CHARGING LOWER
Intel (INTC), daily
PHLX Semiconductor Sector Index (SOX), daily
75 70 65 60 55 50 45 40 35 1200.00 1150.00 1100.00 1050.00 1000.00 950.00 900.00 850.00 800.00 750.00 700.00 651.22 600.00 300,000,000 200,000,000 100,000,000 0 Volume 28 5 11 18 25 2 9 16 23 30 6 13 Sept. Oct. Nov.
2 1 28 5 11 18 25 2 9 16 23 30 6 13 Sept. Oct. Nov.
391⁄32
absence of news, a gap is generally not far behind.
The best way to track volume is by knowing the average daily volume for the stock or sector in question, in combi-nation with its key trading levels (sup-port or resistance). Watching the time and sales ticker is an excellent way to
monitor changing volume for short-term intraday trades. If the ticker is moving fast, you are seeing an increase in vol-ume — it’s that simple.
When this occurs, you are generally looking at a “vertical spread” (VS) situa-tion. A high VS means the price pattern is changing rapidly, up or down, and you will need to “lead” the market (i.e., place a limit order that is the best bid or offer) to buy or sell as the range widens. A slower-moving issue that has a tight “horizontal spread” (HS), where the spread between the bid and ask is tight,
say 1⁄16, will not require leading. If the
stock has a tight HS, you can easily “lift offers” or “hit bids” — or even buy bids and sell offers –— during tight price range situations.
To spot volume changes that may lead to gaps, it is important to take a broader view of both the volume and the market itself. Notice the dramatic volume increase in Intel over the course of sever-al days, in Figure 1. However, the vol-ume interpretation changes within each move and the stock will move the most on the least volume once it is in motion. For example, when stocks are growing weaker, panic and fear is heightened and fewer buyers are stepping up. Therefore, as buyers disappear from the market, stocks fall harder on light volume and with a wider range before new support levels are found. Once the stock estab-lishes support levels, the volume builds dramatically as buyers remain strong, while sellers are still in the market. It is at these levels that the true battle between bulls and bears takes place.
These campaigns are evidenced by
heavy buying and selling, which result in small price movements until one side ultimately gains control. Once a clear imbalance is revealed, whether bullish or bearish, the volume tends to dry up as market participants start to lean over to one side of the supply/demand scale. For example, if the bulls gain control at a
key support level, buyers will exceed sellers and the stock will trade higher on less volume as the buyers lift thin offers at each price level.
The lesson here is that volume indi-cates where the battles are fought between bulls and bears, but once a dominant bias is revealed, the stock will move the most on lighter volume. Gaps are the ultimate example of this: no vol-ume exists, but extreme price change does. Once this gapping action begins, chaos is not far behind.
Chaos and high risk:
Are gaps worth it for you?
Chaos reaches its peak when stocks have no real support or resistance levels in sight. For example, if a stock is not well supported until it trades 20 points lower, volatility will be extreme.
These such conditions re p resent a day-trading environment only. This is not a time to take overnight positions. Remember, volatility can also be defined as chaos and, therefore, you can throw your technical tools and indicators out the window. If you want to day trade in this climate, you must take a micro view of the stock, taking small incremental profits and losses vs. trying to trade the overall trend.
Also important is that gaps often reveal the beginning of new tre n d s . However, if you’re a longer-term posi-tion trader in these situaposi-tions, you must have a much higher risk tolerance because these price fluctuations are part of the equation. Otherwise, you will con-stantly employ “discipline” at the wrong time (placing stops too close, etc.) and
get whipsawed out of trades, taking many losses. Certainly, you also need a clear picture of what the broader price action looks like before even thinking about adding volatile, big-range stocks to your watchlist. It is also important to dramatically lower your size in these trades, because the range of the price
swings offsets the trade size needed to profit.
Seeing the broader view of the market is like a hurricane: When you’re in it, it is chaos, but if you can get far enough away, you can see the larger pattern and d i rection. When you trade chaotic stocks, you must trade them accordingly or avoid them altogether.
To determine if a chaotic market cli-mate in general, and the overnight-gap trade in particular, is for you, ask your-self the following questions:
1. Do I have the account size required
to take the necessary risk?
2. Do I have the temperament and
the required level of risk tolerance?
3. Am I “in the money” and willing
to take on additional risk for additional reward?
4. Do I have clarity and confidence
enough to see the gap coming?
5. Did I day trade this stock the entire
day prior to the anticipated gap? If you answered “no” to any of these questions, don’t even think about taking the trade. If you answered “yes” to all of the questions, then you have the criteria to attempt it. Here’s how to do it.
Taking the trade
Let’s begin with the fact that, because of volatile price pattern movements during the day, stocks will tend to overreact or overtrade, moving to extreme price lev-els that are extreme. This sets up a possi-ble correction for the next trading ses-sion, when market makers will often gap the stock price to levels that are advanta-geous for them.
The first gap that sets the stock in
8 www.activetradermag.com • March 2001 • ACTIVE TRADER
Stocks tend to overreact and move to extreme price levels,
which sets up the possibility
motion because of unforeseeable news is generally not predictable. However, the gaps that may follow can occur for some of the following reasons:
• Additional news, such as earnings releases.
• Short squeezes and profit taking (“hook” closes).
• S&P 500 futures volatility.
These different factors can provide various signals that offer opportunities for gap trades.
Earnings. Earnings are perhaps the
most significant factor re g a rding gap trades, because they have such a sub-stantial impact on both stocks and sec-tors.
The market is far more unforgiving of missed earnings than it is re w a rding to earnings that meet estimates. Many com-panies meet expectations and still get h a m m e red the day after their
announce-ments. This is because most positive earn-ings expectations are built into the stock price in the days prior to the report. For this reason, stocks have a greater pro p e n-sity to fall when companies merely meet e x p e c t a t i o n s .
When expectations are missed, the downside bias is dramatic. Therefore, you should rarely take an overnight position in a company that is reporting earnings after the close. If you do, your natural bias should be to trade the short side — especially in this market environ-ment, where good earnings are often no match for inflationary pressure, rising interest rates and oil prices.
Because so many stocks have an upside bias in the days prior to an earn-ings report, it is best to sell into the news if you’re long the stock, and wait for the outcome. Figure 2 is an example of what companies experience when they miss
expectations.
Short squeezes and profit taking.
Short squeezes and profit taking are the most common reasons stocks will tend to build above-average volume into the close and cause what is called a “hook” close.
In a short squeeze, a stock is in a d o w n t rend and market makers suspect t h e re may be many short sellers in the market. The squeeze and the hook occur when the professionals begin to buy the stock rapidly into the close, causing price to rise swiftly and forcing the short sell-ers to cover in a panic. Profit taking gen-erally occurs when a stock is in a rising t rend but shows a weak close accompa-nied by high volume. At this point, traders with long positions begin to sell the stock to take a profit. Figure 3 shows an example of a short squeeze, while F i g u re 4 is an example of a hook formed
ACTIVE TRADER • March 2001 • www.activetradermag.com 9
Source: QCharts by Quote.com
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.
FIGURE 2 EARNINGS DISAPPOINTMENT
American Power Conversion (APCC), 10-minute
22 21 20 19 18 17 16 15 14 131⁄ 16 1,000,000 500,000 255,300 0 Volume 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 1 1 10/20 Friday 10/23 Monday 10/24 Tuesday 10/25 Wednesday 10/26 Thursday 10/27 Friday 10/30 Monday
during profit taking.
If you’re not in a profitable situation from day trading the stock, you should not take the overnight gap trade. It is best to stand aside and trade the open the following day, after the stock gaps open — if it does. If you had a profitable day-trading session, you can take the overnight position if you think the risk-re w a rd risk-relationship is satisfactory. R e m e m b e r, when going after an overnight position, it must always be with purpose and confidence. Never
hold a losing position overnight, hoping the stock will “come back.” That is noth-ing but gamblnoth-ing.
S&P 500 futures. S&P 500 futures are
an important consideration when taking an overnight gap trade. You should look at the correlation between the futures market and the index in relation to the gap-trading plan you have in mind. If the futures are moving decisively higher going into the close, and you have other independent reasons for the stock in question to gap higher the next day, and
all other questions and factors can be a n s w e red favorably, you could keep your long position overnight.
The point is you must have clarity and confirmation on all levels when taking a position overnight. Still, the most signif-icant piece of information comes from the stock itself and how it behaved while you where trading and watching it in the days prior to the anticipated gap. Without this information, you will not be able to make a decision whether to take a gap trade or not.
Gap trading is a risky business, and the professionals who quote stocks up or down prior to the open have a vested i n t e rest in doing so. If you were a market maker who made your living buying and selling stocks from the public while pro-viding liquidity to the market, where would you open a stock with poor news knowing you were to receive market on
10 www.activetradermag.com • March 2001 • ACTIVE TRADER
The first gap that sets the stock
in motion because of unforeseeable news
is generally not predictable.
Source: QCharts by Quote.com
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 691⁄
2
becoming resistance.
FIGURE 3 SHORT SQUEEZE
Amgen (AMGN), 5-minute 72
70 68 66 64 62 60 591⁄8 1,200,000 1,000,000 800,000 600,000 400,000 200,000 0 1,057,900 Volume 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
open orders? You would open it as low as possible, where you felt the stock was well supported. This is known (from the market maker’s perspective) as “buying w e a k n e s s . ”
Conversely, with strong news, know-ing you would be sellknow-ing at the open, where would you open the stock? The higher the better, so that you could short
stock to buyers at what would be a sig-nificant resistance level. This is referred to as “selling strength.”
This is why gaps have a greater pro-pensity to close immediately after the open: After the initial panic selling or mania buying has been gobbled up by the market maker or specialist, a vacuum often develops and the stock will re v e r s e .
By contrast, if the stock continues to fol-l o w - t h rough in the direction of the gap, it’s a strong indication that the trend will con-tinue.
Remember, however, that while these rules are good to use as a guide, they should not be traded with indiscretion. There are many factors that impact any
individual gap-trading situation.
Ý
ACTIVE TRADER • March 2001 • www.activetradermag.com 11
Source: QCharts by Quote.com
Transwitch Corp. (TXCC) was on its way to recovery from a sell-off in the fiber optic group. Along the way, profit taking on Oct. 30 forced the price lower at the end of the day. The next morning the stock gapped higher, with the buyers once again firmly in control.
FIGURE 4 PROFIT-TAKING
Transwitch Corp. (TXCC), 5-minute
56 54 52 50 48 46 44 42 200,000 150,000 100,000 50,000 8,200 565⁄ 16 Volume 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 Tu e s d a y
The market is far more unforgiving of missed earnings
than it is rewarding to earnings that meet estimates.
You should rarely take an overnight position in a company
that is reporting earnings after the close. If you do,
your natural bias should be to trade the short side.
Trading Strategies
Trading Strategies
&
FUTURES OPTIONS
Trading the
OPENING GAP
Watching pre-market volume is a good way to determine whether
to trade or fade the opening move.
BY JOHN CARTER
O
pening price gaps — thedistance between the reg-ular-session opening price and the previous day’s closing price — are stomach-churning events when the market makes a big move against you, but they represent low-risk trade opportunities if you know which gaps are likely to be followed by predictable patterns.
In terms of the price behavior that fol-lows opening gaps, not all markets are created equal. Gaps in individual stocks and commodities do not act the same as
those in “multi-item” instruments such as stock indices because a news item will control the entire market instead of just a portion of it. Earnings announcements, corporate scandals and other company-specific events can create gaps in a com-ponent stock’s chart that never get filled. Because of the unpredictable nature of various events that can impact the price of an individual stock, they make poor candidates for the opening-gap trade.
In contrast, stock index futures such as the E-mini S&P (ES) or the mini-sized Dow (YM) are better candidates for opening-gap plays because they consist of multiple components that respond dif-f e rently to news. For example, although a stock index futures contract may gap up on a news item, there will be individual stocks within the index that will either i g n o re the news or sell off. This weighs the index down and creates a trade opportunity as the market fills the gap.
The best markets for gap plays
The S&P 500 and the Dow are the best markets to trade the opening gap
because of the diversity of their compo-nent stocks. Both indices re p resent collec-tions of stocks from diff e rent industries that are more likely to react independent-ly to news events. In the technology-heavy Nasdaq, opening price gaps can take longer to fill because the majority of the stocks will react similarly to news.
The key to trading opening gaps is being able to predict the likelihood a particular gap will be filled. Dissecting the market conditions that produce a gap is as important as analyzing a gap itself. For example, an opening gap fol-lowing high pre-market cash trading volume can take weeks to get filled because high volume increases the odds the market will continue to move in the direction of the gap.
Some of the biggest gaps are caused by major news events, such as the out-break of a war, but gaps caused by minor news items are much more common. G e n e r a l l y, such gaps are smaller, fill quickly (see Table 1) and can be “faded” (the act of trading against the direction of the gap) more effectively. Let’s look at Between Jan. 15, 2002, through
February 2004 (528 occurrences), an average of 76 percent of all opening gaps closed at some point during the same day. This is the breakdown by day of week. Adding the pre-market volume filter increased the percentages.
TABLE 1 FILLING THE OPENING GAP: RAW DATA
Source: Tradethemarkets.com
Percentage of Day gaps filled
Monday 65%
Tuesday 77%
Wednesday 79%
Thursday 82%
Friday 78%
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 -ume is above 70,000.
TABLE 2 TRADE MANAGEMENT GUIDELINES
Source: Tradethemarkets.com
Pre-market volume
in key stocks Position size Trade target
Less than 30,000 Full size Exit entire position at gap fill
Between 2/3 size Exit half at 50 percent of gap
30,000 and 70,000 fill, half at gap fill
Above 70,000 No “fade” trade No “fade” trade
the specific criteria for identifying those gaps with the best chances of reversing.
The pre-market volume indicator
The most important indicator for deter-mining which opening gaps can be faded is the pre-market volume in a spe-cific set of stocks.Check the pre-market volume at 9:20 a.m. ET (10 minutes before the re g u l a r cash session opens) in the following stocks: KLA-Tencor Corporation (KLAC), Maxim Integrated Products, Inc. (MXIM), Novellus Systems, Inc. (NVLS) and Applied Materials, Inc. (AMAT). These re p resentative stocks were selected t h rough a trial-and-error pro c e s s .
If the market is really set up to move, there will be significant volume in the cash market in pre-market trading. If the market is setting up for a “head fake” (a move in one direction that is quickly reversed), pre-market volume will be low, which reflects a lack of conviction in the move. This is the preferred setting for an opening-gap trade.
If the pre-market stocks have each traded less than 30,000 shares at this time, analysis of the prior 500 trading days shows the opening gap, up or down, had an 80-percent chance of fill-ing the same day. However, if the vol-ume for each stock is between 30,000 and 70,000, the gap only has about a 60-percent chance of filling that day, while the midpoint of the gap has an 85-per-cent chance of being hit.
Finally, if the pre-market volume for each stock is above 70,000, the chances of the gap filling that day drop to 30 per-cent. In these cases, you should ignore the news and follow the direction of the gap. Table 2 provides guidelines for using volume information to manage trades. As the volume increases, the position size shrinks and the profit-tak-ing becomes more conservative.
If one stock has volume above 70,000 but the others are below the threshold, check to see if the news pertains to this company alone. If it does, ignore it. If the news is not specific to the company, trade the more conservative position.
The strategy
Figure 1 is a five-minute chart of the
mini Dow futures. You can use any time interval — a one-minute, five-minute or 15-minute chart, etc. — as long as you can view the opening. This means the chart must be set up to reflect the open-ing and closopen-ing of the regular tradopen-ing session, 9:30 a.m. to 4 p.m. ET (4:15 p.m. for stock index futures prices). Many traders are used to watching a separate chart of the continuous 24-hour futures session, but of course, opening gaps
won’t show up.
Figure 1 shows the first day in a set of back-to-back earnings announcements that caused opposite reactions in the market. On the morning of Oct. 15, 2003,
the Dow gapped up 47 points as a result of a positive earnings report from Intel (INTC). On this day, pre-market volume was below 30,000.
As a result, the appropriate trade is to immediately short the gap on the open using a full position size, as indicated in Table 2. To keep things simple, we’ll use nine contracts as a full position, which makes a two-thirds position six contracts and a one-third position three contracts.
We will use a $100,000 account, which means we are trading one contract for each $11,100 in the account for a full posi-tion. Although you can trade a mini Dow or E-mini S&P contract with only a few
ACTIVE TRADER • December 2004 • www.activetradermag.com 13
Mini Dow futures (YM), five minute Gap is filled for a 47-point
gain, or $235 per contract (47 points x $5 per point).
11:00 12:00 13:00 14:00 15:00 9:00 10:00 10/15/03 9,830 9,820 9,810 9,800 9,790 9,780 9,770 9,760 9,750 9,740 9,730 9,720 9,710 9,700 This 47-point-plus opening gap in the mini Dow futures was filled in the first hour of trading for a $235 per-contract profit.
FIGURE 1 THE OPENING GAP
Source: eSignal
If the market is poised to move, there
will be significant pre-market volume
in certain stocks.
FUTURES OPTIONS
&
Trading Strategies
Trading Strategies
continued
thousand dollars, this trading plan con-t rols risk by limicon-ting exposure re l a con-t i v e to the amount of available capital.
Use a 1:1.5 re w a rd/risk ratio (risking 1.5 points to make 1 point) for gap trades that are less than 40 mini Dow points or 4 E-mini S&P p o i n t s. For gaps l a rger than these, use a 1:1 re w a rd / r i s k ratio. In the case of Figure 1, we would risk 47 points to make 47 points. If the gap had been 30 points, we would risk 45 points.
Some traders might question an a p p roach that risks more than the potential profit. Most beginning traders are taught to use a 3:1 reward/risk ratio, risking 1 point to gain 3. They inevitably wonder why they are repeat-edly stopped out just before the market turns. In general, wider stops produce more winning trades; the key is to trade only those setups with a better than 80-percent chance of winning.
The market sold off immediately after the bell, filling the opening gap within an hour. Ironically, the next day IBM came out with a disappointing earnings report, knocking the market down on the open. Figure 2 shows the resulting buy setup had just a small open loss at one point, although many traders might have been stopped out on the pullback around 11 a.m. ET. However, keep in mind the strategy is to maintain a reward/risk ratio of 1:1, not to tighten your stop when the market moves in your favor. If the stop had been hit, the loss would have been approximately $305 per contract ($2,745 for the nine-contract full position), not including slippage and commissions. This loss is rea-sonable because of the 80-percent success rate of the setup.
Using a tighter initial stop or trail-ing stop would have turned this position into a losing trade or, at best, a breakeven trade. Using the risk parameters designed for this trade setup allowed the position to remain open until the gap was filled for a gain of 61 points. As a rule, using a trailing stop will negatively affect the gap trade’s win/loss ratio.
When the trade is executed, the best thing a trader can do is to walk away and let the orders do their work. This is the diff e rence between
p rofessionals and amateurs:
P rofessionals won’t second-guess a
14 www.activetradermag.com • December 2004 • ACTIVE TRADER
E-mini S&P 500 continuous contract (ES), five minute Close on 7/30/04: 1,103.75 Open on 8/2/04: 1,097.00 1 4 : 4 5 1 5 : 0 51 5 : 2 5 1 5 : 4 5 8 / 2 1 0 : 0 0 1 0 : 2 01 0 : 4 01 1 : 0 0 1 1 : 2 0 1 1 : 4 01 2 : 0 0 1 2 : 2 0 1 2 : 4 0 1 3 : 0 0 1 3 : 2 01 3 : 4 0 1,106 1,105 1,104 1,103 1,102 1,101 1,100 1,099 1,098 1,097 1,096 The E-mini S&P futures made a downside opening gap on Aug. 2, 2004, on terrorist threats. The market spent most of the day filling the gap.
FIGURE 3 EMOTIONS TRIGGER GAP
Source: TradeStation
Mini Dow futures (YM), five minute
Gap filled for a 61-point gain, or $305 per contract.
15:00 9:00 10:00 11:00 12:00 13:00 14:00 10/16/03 9,800 9,790 9,780 9,770 9,760 9,750 9,740 9,730 9,720 9,710 9,700 One day after the trade setup shown in Figure 1, the mini Dow contract opened lower, setting up a long trade.
FIGURE 2 THE DAY AFTER
trading methodology, while ama-teurs are constantly adjusting.
Ignore the reasons for the gap
The size or cause of a gap has little impact on whether or not it will be filled. Figure 3 shows an example of emotions triggering an opening price gap when, on Aug. 2, the market gapped down on the open because the U.S. government issued a terror warning the previ-ous day. There were rumors of a plan to blow up a large financial institution.H o w e v e r, after a choppy first half of the day, the market firmed, shorts got nervous and started cov-ering, and the gap was filled by 1:30 p.m. ET for a 6.75point S&P E -mini profit ($337.50 per contract).
Relax and trade
F i g u re 4 shows a 15-minute chart of the September mini Dow future s (YMU04) with an opening gap on Aug. 18 that did not get filled for six trading days. (Other opening gaps occurred before price eventu-ally filled the first gap.) On this day, the mini Dow gapped up a modest 44 points prior to the release of some economic numbers. The pre-market vol-ume was modest, between 30,000 and 70,000 shares for the key stocks, so the a p p ropriate step was to short a two-t h i rds-size positwo-tion on two-the open.
The market rallied, sold off a little just prior to the economic numbers, and then shot higher once the numbers were released. Using the 1:1 reward/risk ratio resulted in a 44-point stop. The market never retraced to the gap’s midpoint level (where half the position could be c o v e red), and instead rallied right through the stop, producing a loss of $220 per contract. For a two-thirds posi-tion (six contracts) the loss was $1,320.
This move left an open gap below the market. The next day the market opened modestly lower, triggering a long trade that resulted in a quick $65-per-contract profit ($585 total). The following day the market opened 52 points lower and filled the gap a few hours later for a $ 2 6 0 - p e r-contract profit ($2,340). The next day, the market gapped up 44 points, triggering a short trade that came close to the stop-loss point, but eventual-ly filled the gap for a $255-per-contract
profit ($2,295). All these gaps followed light pre-market volume, so they were executed with full positions.
On Aug. 22, 2003, Intel announced “cautious upside earnings re v i s i o n s . ” The market exploded to the upside and gapped right above key resistance. The trade was to short the 62-point gap with a full-size position. Six bars later, the tar-get was hit for a 62-point profit, or $310 per contract ($2,790).
During the afternoon session, the mar-ket traced out a bear flag pattern. Wi t h the opening gap under the market still unfilled, the trade was to place a sell stop at 9,392 to let the trend of the market ini-tiate the trade based on a breakdown of the flag. The entry stop was filled and the risk point for the trade was above
intra-day resistance at 9,455.The target was the
Aug. 18 gap at 9,304. The market spent the rest of the day trending lower, filling the gap and resulting in an 88-point gain, or $440 per contract ($3,960).
A brief window of opportunity
The market’s nature is to prevent as many people as possible from consis-tently making money, which is why it is crucial for a trader to follow rules for
each type of trade setup.
Gaps are the one moment of the trad-ing day where everyone has to show their poker hand, and this creates a big advantage for short-term traders. Understanding the dynamics behind opening gaps is paramount to trading
them successfully.
Ý
For information on the author see p. 10.
ACTIVE TRADER • December 2004 • www.activetradermag.com 15
Mini Dow September futures (YMU04), 15 minute
Gap of +62 points fills in 6 bars Short break of bear
flag. Target is gap from 8/18
Gap of +44 points fills in 9 bars Gap of -52 points fills in 9 bars Gap of +13 points fills in 1 bar Gap on 8/18 of +44 points fills on 8/25 8 / 1 8 1 3 : 1 5 8 / 1 9 1 1 : 4 5 1 4 : 1 5 8 / 2 0 1 2 : 4 5 8 / 2 1 1 3 : 4 5 8 / 2 2 1 2 : 1 5 8 / 2 5 1 3 : 1 5 8 / 2 6 9,500 9,480 9,460 9,440 9,420 9,400 9,380 9,360 9,340 9,320 9,300 9,280 The first opening gap on this chart — which remained unfilled for the next six days — set up a short trade that was stopped out for a loss. Subsequent opening gap trades were more successful.
FIGURE 4 MULTIPLE GAPS
Source: TradeStation
Related Active Trader
articles
“Trading the overnight gap” by David Nassar, March 2001, p. 66
“Morning reversal strategy” by Bryan C. Babcook and Arthur Agnelli,
May 2003, p. 36
“Technical Tool Insight: Gaps,” April 2003, p. 82
“Technical Tool Insight: Islands,” August 2002, p. 82
You can purchase past articles online at www.activetradermag.com/ purchase_articles.htm and download them to your computer.
16 www.activetradermag.com • May 2003 • ACTIVE TRADER
Markets:Any.
System concept: Most traders are familiar with the technical analysis axiom, “All gaps are eventually closed.” A gap occurs when a price bar’s high is lower than the previous low or its low is higher than the previous high. A significant gap creates a void in which no trades occur, as shown in Figure 1. An “open-ing gap” occurs when price opens above the previous high or below the previous low; such gaps can be filled the same bar, in which case no visible bar-to-bar gap (such as the one in Figure 1) will appear on the chart.
The idea that gaps are eventually closed stems from the absence of trades within the range of the gap. Because there are no traders who are holding positions within the gap zone (some may have entered positions earlier in the chart’s history), there is an absence of the
upside resistance that is typically caused by traders seeking to exit at breakeven or a profit-target level. Because of this lack of
resistance, price often moves sharply to close the gap when it first recovers and penetrates the gap zone. This type of price movement can also lead to the “island reversal” pattern, which occurs when a gap in one direction is followed by (after one or more intervening bars) a gap in the opposite direction.
This test is designed to see if the axiom regarding closing gaps holds water. The system tested here goes long the day after a large gap down and holds the position until price reaches the low of the bar immediately before the gap — i.e., when the gap is closed.
This “system” is for experimental pur-poses only. The goal is to test the effective-ness of trading gaps in the simplest way possible; no protective stops are included. Because of this, positions can be held indefinitely and result in substantial draw-downs when gaps are never closed. If you wanted to actually trade a gap-based sys-tem, you would most likely use a protec-tive stop to protect against these losses.
Rules:
1. Enter long on the open the day after a
down gap greater than the 20-bar aver-age true range (ATR) is completed.
2. Place a limit order to sell the position at
the low price of the bar that immediate-ly preceded the gap.
3. The system will maintain multiple
1 3 0 , 0 0 0 1 2 0 , 0 0 0 1 1 0 , 0 0 0 1 0 0 , 0 0 0 9 0 , 0 0 0 8 0 , 0 0 0 7 0 , 0 0 0 6 0 , 0 0 0 5 0 , 0 0 0 4 0 , 0 0 0 3 0 , 0 0 0 2 0 , 0 0 0 1 0 , 0 0 0 0
E q u i t y Cash Linear reg
FIGURE 1 EQUITY CURVE
3/3/93 1/7/94 1/3/95 1/2/96 1/2/97 1/4/99 1/3/00 1/2/01 1/2/02 1/2/03
Gap closer
FIGURE 2 SAMPLE TRADES
Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)
Apple Computer (AAPL), daily
Volume
10 gaps, seven closed (70%)
Buy
Buy
July 2002 August 2002 September 2002
2 5 . 0 0 2 4 . 0 0 2 3 . 0 0 2 2 . 0 0 2 1 . 0 0 2 0 . 0 0 1 9 . 0 0 1 8 . 0 0 1 7 . 0 0 1 6 . 0 0 1 5 . 0 0 1 4 . 0 0 2 0 M
The system went long when Apple Computer gapped down more than 13 percent on June 19, 2002. Price started moving in the direction of closing the gap, but another down gap occurred on July 17, 2002, causing a new long position to be established.
The frequency of down gaps increased after the broad market topped out in early 2000. The system exposure (light green area) increased substantially after this point. Note that many of these gaps are still open.
ACTIVE TRADER • May 2003 • www.activetradermag.com 17
open long positions (see Figure 2).
4. Hold the position indefinitely until the gap is
closed and the limit sell is triggered.
Money management:Risk 9 percent of account equity per trade. This level was chosen because it was the largest position size that allowed all gaps to be traded during our test period.
Starting equity: $100,000 ($10 slippage/com-mission deducted per trade).
Test data: The system was tested on the Active
Trader Standard Stock Portfolio, which contains
the following 18 stocks: Apple Computer (AAPL), Boeing (BA), Citibank (C), Caterpillar
(CAT), Cisco (CSCO), Disney (DIS), General Motors (GM), Hewlett Packard (HPQ), International Business Machines (IBM), Intel (INTC), International Paper (IP), JPMorgan Chase (JPM), Coke (KO), Microsoft (MSFT), Sears (S), Starbucks (SBUX), AT&T (T) and Wal-Mart (WMT).
Test period:January 1993 through January 2003.
System results: A total of 62 gaps occurred during the 10-year test period. Of these, 50 (80 percent) were closed for a profit. The remaining 12 gaps were open at the end of the test period. The average profit for the closed gaps (which took, on
aver-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.
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
opposed to cash • Profit factor — gross profit divided by gross loss • Payoff
ratio — average profit of winning trades divided by average loss of losing
trades • Recovery factor — net profit divided by max. drawdown • Max DD
(%) — largest percentage decline in equity • Longest flat days — longest
period, in days, the system is between two equity highs • No. trades — num -ber of trades generated by the system • Win/Loss (%) — the percentage of 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-ners) — the average holding time for winning trades • Avg. loss (losers) —
the average loss for losing trades • Avg. hold time (losers) — the average holding time for losing trades • Max. consec. win/loss — the maximum number of consecutive winning and losing trades
LEGEND: Avg. return — the average percentage for the period • Sharpe ratio — average return divided by standard deviation of returns (annualized) • Best return — best return for the period • Worst return — worst return for
the period • % Profitable periods — the percentage of periods that were prof itable • Max. consec. profitable — the largest number of consecutive prof itable periods • Max. consec. unprofitable — the largest number of consec -utive unprofitable periods
Trading System Lab strategies are tested on a portfolio basis (unless otherwise noted) using Wealth-Lab Inc.’s testing platform.
If you have a system you’d like to see tested, please send the trad-ing and money-management rules to [email protected].
age, 100 trading days to close) was just under 11 percent. By comparison, the average loss of the 12 gaps that are still open is a sharp -32 percent, and the average number of trading days they have been open is about 350 (about one and a half years). That most of the gaps in the test portfolio within the past 10 years have been closed reinforces the idea that gaps do have a tendency to get filled — although it often takes a while. However, the damage done by the minority of gaps that did not close wiped out most of the profits achieved from the majority of gaps that did close. This leads to the conclusion that trading gaps on their own entails significant risk.
However, it is possible to combine gaps with other trading tools and methods. The old saying, “All gaps are eventually closed,” may not be totally accurate, but knowing the odds are good that a certain price target will be reached can play an
important role in a trading strategy.
Ý
— Compiled by Dion Kurczek of Wealth-Lab Inc. FIGURE 3 DRAWDOWN CURVE
P r o f i t a b i l i t y Trade statistics
Net profit ($): 1 1 , 9 4 2 No. trades: 6 2 Net profit (%): 1 1 . 9 4 Win/loss (%): 8 0 . 6 5 Exposure (%): 2 8 . 4 2 Avg. gain/loss (%): 2 . 6 9 Profit factor: 1 . 2 7 Avg. holding time: 1 4 8 . 1 5 Payoff ratio: 0 . 3 4 Avg. profit (winners): 1 0 . 9 7 Recovery factor: 0 . 3 5 Avg. hold time (winners): 1 0 0 . 0 6
D rawdown Avg. loss (losers) %: - 3 1 . 8 0 Max. DD (%): - 2 4 . 7 5 Avg. hold time (losers): 3 4 8 . 5 0 Longest flat days: 4 6 5 Max. consec. win/loss: 3 8 / 4 STRATEGY SUMMARY
PERIODIC RETURNS
As more gaps were opened and more long positions established, a large drawdown began in 2000.
3/3/93 1/28/94 2/1/95 1/30/96 2/3/97 1/4/99 1/3/00 1/2/01 1/2/02 1/2/03
Avg. Sharpe Best Worst % Max. Max. return ratio return return Profitable consec. consec.
periods profitable unprofitable
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 Quarterly 0.43% 0.15 16.34% -14.11% 53.66% 3 3 Annually 1.60% 0.22 10.73% -12.90% 60.00% 4 1 0% -2% -4% -6% -8% -10% -12% -14% -16% -18% -20% -22% -24%
Markets:Any.
System concept:The stock Trading System Lab (p. 54) fea-tured an experimental system designed to trade gaps. The intention was to go long on every down gap and hold the position until the gap was closed (if it ever closed). This pro-vides useful information about the dynamics of gap behav-ior.
However, it is not possible to hold a losing futures posi-tion in a similar manner because the higher leverage in futures results in losses of a much larger magnitude. Taking this into account, the futures system goes long right when price is starting to fill a down gap. The absence of resistance in the price void of the gap should provide positive momen-tum for a long trade. Based on the results of the stock test, it is likely most of the gaps will be filled.
In addition, this system uses three different exits to pro-tect capital while giving trades room to breathe. The strate-gy uses a breakeven stop entered soon after the trade is prof-itable to protect against a reversal. When the gap is not filled and prices do not reach our breakeven level, we employ a wide stop-loss order.
The system should have a large number of winning and breakeven trades, and a small number of large losses. Because of the high expected win-loss ratio, the strategy uses an aggressive maximum risk setting (10 percent equity loss per
trade). All traders must weigh these considerations and deter-mine their personal risk tolerance when deciding on the
stop-loss and maximum risk levels.
Rules:
1. A long entry setup occurs when there is
a down gap greater than the 20-bar aver-age true range (ATR). Multiple open trades are acceptable.
2. Go long on a buy stop order at the high
of the down-gap bar plus one tick.
3. Exit with a profit using a limit order at
the low of the bar that preceded the down gap.
4. Place a stop-loss order below the entry
price that is three times the distance between the entry price and the profit target level.
Note: Wait until the close of the entry bar
before placing the profit target and stop-loss orders.
5. As soon as the contract closes with a gain
of at least one percent, place a breakeven
stop to exit at the entry price.
Risk control and money management:
1. Starting equity: $100,000. Deduct $10
slippage/commission per contract
(entry and exit).
2. The number of contracts to buy is
deter-mined by calculating the distance between the entry price and the initial stop-loss level. Buy the number of contracts that results in a maximum loss of 10 percent if the stop-loss is hit.
FIGURE 2 SAMPLE TRADES
Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)
Gold futures (GC), daily
Volume
May 1999 June 1999 July 1999 August 1999 September 1999 October 1999
3 7 0 . 0 0 3 6 0 . 0 0 3 5 0 . 0 0 3 4 0 . 0 0 3 3 0 . 0 0 3 2 0 . 0 0 3 1 0 . 0 0 3 0 0 . 0 0 2 9 0 . 0 0 1 0 0 , 0 0 0 2 0 0 , 0 0 0 1 9 0 , 0 0 0 1 8 0 , 0 0 0 1 7 0 , 0 0 0 1 6 0 , 0 0 0 1 5 0 , 0 0 0 1 4 0 , 0 0 0 1 3 0 , 0 0 0 1 2 0 , 0 0 0 1 1 0 , 0 0 0 1 0 0 , 0 0 0 9 0 , 0 0 0 8 0 , 0 0 0 7 0 , 0 0 0 6 0 , 0 0 0 5 0 , 0 0 0 4 0 , 0 0 0 3 0 , 0 0 0 2 0 , 0 0 0 1 0 , 0 0 0 0
Equity Cash Linear reg
FIGURE 1 PORTFOLIO EQUITY CURVE
8/16/93 7/4/94 6/2/95 5/1/96 4/1/97 3/2/98 1/3/00 1/2/01 1/2/02
Trading System Lab
Trading System Lab
FUTURES
Gap closer
Gaps in gold trigger two trades. The green lines represent the entry points and the red lines represent the profit-target exits. Notice how prices gapped up to close the first gap down, forming an island reversal. The second gap also closed, but not before the trade was stopped out. Increasing the stop-loss distance would have turned this trade into a winner.
The equity curve exhibits some volatility, but also an overall upward bias and extremely low market exposure. This is a result of the small number of trades, as well as their short holding periods.
