The Key to Profiting from the Opening Gap
Gaps are important to traders of all types and time-frames because of their frequent occurrence and strong, proven tendencies to “fill” (i.e. retrace back to their prior day closing price). Opening gaps in the equity indices such as the S&P 500, Russell 2000, NASDAQ 100 and Dow 30 are especially prone to filling. Unlike an individual stock, their diversity makes it more difficult for a single piece of news or event to sustain that opening move for the entirety of the trading session. As such, over 70% of all opening gaps in the indices have filled the same day that they were created during the past 10 years.
Many traders profits by “fading” (i.e. trading in the opposite direction) the opening gap. With such a proven bias towards filling, you might think that it would be easy to profit from this technique. However, the paradox lies in the fact that a stop loss must be used in order to protect profits from the 25-30% of gaps that do not fill, and that often move aggressively in the opposite direction of the gap. You may profit from a series of smaller gaps that fill successfully, only to watch that one gap continue running away, taking your account and profits right along with it.
Thus, trading gaps poses a difficult dilemma: what size stop loss should be used? If the stop is too tight (i.e. small) then the trader risks being stopped prior to the gap filling. If the stop is too large, then the trader’s losses will erase some or all of the profits from the winners.
Whether you are a day trader seeking to profit from the opening gap or a swing trader looking to optimize your position entry, the first key to success is being able to identify those gaps that are most likely to fill (i.e. common or exhaustion gap vs. continuation or breakaway gap). Depending upon where the index opens relative to its prior day’s open, high, low and closing prices will dramatically influence its probability of filling. By using these four important price levels (O,H,L,C) and incorporating the prior day’s direction (up or down), you can create 10 “zones” – each with its own historical probabilities. With history on your side, you can better identify the riskiest gap setups while capturing the most probable winners.
Join me for my 30 minute webinar on January 4, 2010 where I will discuss my gap trading methodology which has helped me capture 23 profitable months and only 3 small losing months while trading the opening gap since the markets peaked in October of 2007.
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Scott Andrews trades gaps for a living and is president of www.MasterTheGap.com, an education service which provides daily probabilities and tools to help traders more profitably play opening gaps. Demand for Mr. Andrews' research from other traders led to the establishment of MasterTheGap.com in 2007. Prior to trading, he co-founded SciQuest, Inc. to streamline the procurement processes for healthcare and academic organizations and took the company public as CEO in 1999. He is the author of Understanding Gaps (published by TradersPress.com) and is a frequent speaker at trading and financial conferences. Mr. Andrews earned his MBA from the University of North Carolina, graduated from the United States Military Academy at West Point, and is a decorated aviator of the first Gulf War.