How To Trade Gaps
When traders refer to trading gaps, they refer to the technical phenomenon where the stock price moves significantly higher or lower in a short time. But, how do experienced traders find these opportunities that propel them to these remarkable gains? Luckily for you, there is a trading strategy in play that we will go through so that you can find these price movements in hopes of capitalization. So, let us get into it and find out how to trade gaps.
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The Opening Gaps for the Short-term Trader
Each day in the market there is one opportunity that represents the lowest-risk trade available, and that is the opening gaps. Trading the gaps occur when the next day’s regular session opening price is greater or lower than the previous day’s regular session close, creating “gaps” in price levels on the charts, similar to a small child that has just lost his two front teeth.
However, when it comes to trading the gaps, not all markets are created equal. Trading the gaps in “single item” markets does not act the same as trading the gaps in “multi-item” markets. Examples of “single-item” markets include bonds, currencies, grains, and energies. These markets are made up of a single component, and a news item on this single component controls the entire market, instead of just a portion of it.
On the other hand, a “multi-item” market such as the Emini S&Ps makes a great candidate for trading the gaps plays, because there are individual components of this index that will respond differently to various news items. This means that, although the market may gap up on a news item. There will be individual stocks within the index that will either ignore the news or sell off on the news. Weighing the index down and creating an opportunity for the market to fill its gaps. Along these same lines, the Mini-Dow is also a great candidate for trading the gaps, as it is made up of 30 large, well-diversified individual stocks.
S&P and Dow Gaps Are Best
Although the S&Ps and the Dow are the best “trading the gaps” markets to trade, the individual components of these indexes do not set up consistently for these plays. Individual stocks are like politicians, in that each day they can produce a fresh skeleton from the proverbial closet. Earnings announcements, corporate scandals, and insider deals can create gaps in price that never get filled.
Due to the unpredictable nature of the individual stock, they make poor candidates for trading the gaps fill. Along these same lines, the Nasdaq market is heavily weighted towards technology, and trading the gaps in price can take longer to fill as the technology news of the day plays out. In the end, the S&P 500 and the Dow represent a broad array of stocks from different industries, and they are the best markets to play when it comes to trading the gaps.
The magic of trading the gaps is that they are like an open window, and like all windows, at some point, they are going to be closed. The key is to be able to accurately predict when the day’s trading the gaps (window) are going to be filled (closed). What is as important as analyzing the gaps themselves is analyzing the market conditions that produce the gaps. For example, in professional trading, the gaps with high pre-market volume can take weeks to get filled. Much more common are trading the gaps that are news reactions or fishing expeditions. These are smaller in nature, fill quickly, and can be faded regularly.
The Trading Gaps Strategy
Figure 1 reveals a 15-minute chart of mini-Dow September futures. For trading the gaps plays, I set the trading times to match the regular stock trading session, from 9:30 a.m. to 4:00 p.m. ET. This produces a clear visual of the gaps.
Figure 1 shows a 15-minute chart of the September mini-Dow futures, with opening gaps on 7/24 and 7/25.
On the morning of July 24, 2003, the Dow gapped up 64 points. Note the low pre-market volume, which indicates an 80-percent chance of trading the gaps filling that same day. Because of the economic data hitting at 10:00 a.m., the chances of that trading the gaps filling in the first half-hour of trade are as likely as Mariah Carey (in my lifetime), getting the chance to star in a sequel to Glitter.
Therefore, I accumulate a short position in three stages, starting off with one-third size at the open. For the purposes of simplicity, let’s refer to a full position as nine contracts. A one-third lot is three contracts, a two-third lot is six contracts, and so forth. For full positions, I trade one contract for each $11,100 in my account. Although a trader can trade a mini-Dow or E-mini S&P contract with only a few thousand dollars, part of my trading plan includes limiting my risk by limiting my exposure. For the purposes of this article, then, I am trading nine contracts on a $100,000 account.
I set a 1:1 ½ risk/reward ratio (risking one-and-a-half points to make one point) for trading the gaps plays. Therefore, with this play, I am risking 96 points to make 64 points. Most beginning traders are taught by their brokers to use 3:1 risk-reward ratios, risking one point to get three points. As the traders wonder why they always get stopped out just before the market turns, their broker is tallying up commissions generated on the day, while simultaneously contemplating the effects of a third martini. In general, wider stop losses produce more winning trades. The key with wider stops, of course, is to only play setups that have a greater than 80-percent chance of winning.
I shorted three contracts near the open at 9233, with a stop at 9329 and a target of 9169. The markets drift down during the first 15 minutes but do not fill the gaps. As the report nears, the markets firm on nervous short-covering, then pop higher on the report. I short another three contracts on this reaction, keeping the same original stop of 9329 on both lots. I then add my last three contracts when the markets break back below the open at 9233. By 10:40 a.m. Eastern time. I have a full nine-lot short of mini-Dow futures, with a fixed stop and a fixed target. I am now done tweaking this position, and I begin setting up other plays in other markets. I do not mess around with my trading the gaps play. I do not trail my stop. I will either get out on my stop or on my target.
As seen on the chart, the markets sold off and, at around 2:15 p.m. Eastern, my target was hit for a little over 60 points. This is $300 per contract or a total of $2,700 on my nine-contract position. If my stop had been hit, I would have lost approximately $435 per contract or a total of $3,915. I am comfortable with that because I know that 80 percent of the time this trade will work out in my favor. With tighter stops or trailing stops, this would have turned into a losing trade. This is where trading methodology makes all the difference between a professional and an amateur. They are both trading the same exact set-up, but one is losing money while the other is making money.
This same play could have been executed using the DIA, SPY, E-mini S&Ps, and DIA futures. Table 1 shows the set-ups and the number of shares or contracts I would trade on a $100,000 account. The DIA Futures are nice if a trader is using a smaller account. They are a happy medium between having a lot of leverage with the mini-Dow futures and no leverage with the DIA stock.
On July 25, there are small 12-point gaps to play, which fill quickly. On trading the gaps under 50 points in the Dow, or under five points in the S&P, I start with full positions.
The main thing to learn from this example is the importance of scaling while trading the gaps. If the market is going to gaps and keep running away, a trader will only have a 1/3 position, which is much less antagonizing than being in at full size. This will help to give the trader time to observe how the gaps are acting before adding to the position. All gaps are not created equal, and by scaling into a position a trader gets additional time to gauge the strength or weakness of the move prior to making a full commitment.
Stops Make a Difference
The next gaps is the kind that kills amateur traders who are using their tight 3:1 risk/reward ratios. We get a nice opening trading the gaps on the E-mini S&P September futures of 8.50 points, seen in Figure 2. Because this is over five points, I start off only shorting three contracts at the open. The markets sell off a bit in the first 15 minutes, then rally and break new highs in the economic number. I short the second lot of three contracts on the break of new highs. The number hits, and the market sell-off.
Figure 2 displays a 15-minute chart of the September E-mini S&P futures, with a solid opening gap of 8.50 points.
Initially, I am expecting that the markets will quickly fill the gaps in my six-lot position, which is fine with me. But the markets stabilize and start to rally, eventually breaking to new highs. When we get a +1000 tick reading, I add my final three contracts, as I know Alan Greenspan is firing off the last of his market-propping bullets.
I now have a full position, with a stop at 1007.00 and a target at the opening trading the gaps. The markets spent the bulk of the afternoon session trading near the highs, coming within a few points of my stop. However, having been trading the gaps literally hundreds of times and knowing their outcomes based on my checklist, I treat this position like a marriage, and I do not bail or try to change it. Either I will get taken out at my stop, or my target will get filled, for better or for worse.
Later in the session, the markets rolled over, closing weak, but still positive on the day and not having filled the gaps. I kept the position overnight with the same parameters. My target was hit quickly the next day. Why did I hang onto this trade through the day and overnight? It is all in sticking to a pre-determined plan, knowing that the chances for success are 80 percent. I’m out with healthy gains of approximately 8.50 points per contract, or $3,825.
What is important to remember for trading the gaps plays is that an active program of trailing stops will negatively affect your win/loss ratio. Once the parameters are set in place, the best thing a trader can do is to walk away and let the orders do their job. Although tweaking is a good thing to do when giving a car a tune-up, tweaking the parameters of trading the gaps trade is similar to a mother-in-law offering her opinion on how to raise her first grandchild: It won’t be appreciated and, bottom line, it won’t work.
Relax While Trading the Gaps
The example in Figure 3 is my favorite type for trading the gaps. I called it the “Bahamas Gaps” as it represents a low-stress trade. Because trading the gaps is less than five points, I take a full position right at the open. The gaps never challenge my stop, and I am filled in eight bars, for a gain of $212.50 per contract ($1,912.50). On the next trading day, there is a small gaps of 0.25 points. I ignore this. Gaps of under one S&P point or ten Dow points are not worth playing.
Figure 3 shows a 15-minute chart of the September E-mini S&P futures, with a modest opening gap of 4.25 points on 8/8 and an unplayable gap of 0.25 points on 8/11.
Okay, now what about trading the gaps that don’t fill for a few days? You have to love it when these “open windows” are out there in the markets. They act as black holes, eventually sucking prices back to their gapping levels. On August 18, we gapped up a modest 44 points in the Dow prior to some economic numbers, as seen in Figure 4. I am short in the open. We rallied, sold off into the economic numbers, and then shot higher once the numbers were released. I had a 66-point stop, and the markets rallied just through that level, producing a loss of $330 per contract, or $2,970.
I head into the next trading day knowing there is now a “black hole” gaps below. I can actually hear the sucking sound. The next day we have modest gaps that work out quickly, for $65 per contract ($585). The day after, we get a nice 52-point gaps that take a few hours to fill, but creates a few headaches, for $260 per contract ($2,340). The next day we get 44-point gaps that come close to our stop but eventually fill the gaps for $255 per contract ($2,295). Finally, on August 22, we get the “sucker gaps” when Intel announces “cautious upside earnings revisions.” The market explodes and trades the gaps right into key resistance.
Figure 4 shows a 15-minute chart of the September mini-Dow futures, with a gap on 8/18 that does not get filled for 6 trading days. In addition, there are numerous gaps to play while this 8/18 gap undergoes the process of closing its window.
I short the gaps, adding to full size as we dip back below the opening price. Six bars later, my target is hit for 62 points or $310 per contract ($2,790). The sucking sound of the black hole below is getting louder. During the afternoon session, we get a bear flag consolidation. I set up a “sell stop” at 9392 to let the market take me into a breakdown of that flag formation.
I get the fill and set my stop above intraday resistance at 9455. My target is the 8/18 “black hole gaps” at 9304. The market spends the rest of the day on its hands and knees, dry heaving, trying to hold back the internal pressure. This pressure proves to be too much and, like a freshman college student during his first year away from home, the market eventually falls over and vomits. I hold my position over the weekend, and Monday morning the markets quickly fill the gaps for an 88-point gain or $440 per contract ($3,960).
One of the many benefits of trading the markets is the freedom it provides. However, so much freedom comes with a price: The markets cannot protect a trader from him or herself. An individual trader is unsupervised and has the freedom to act unchecked in any way they choose. This freedom typically reinforces bad habits, and the net result is a market that moves and thrives in such a way as to prevent as many people as possible from consistently making money. This is why it is imperative for a trader to have a set of rules to follow for each type of trade setup. Rules are created for a trader’s own protection.
As an example, trading the markets is very similar to walking up to a pride of lions in the middle of Botswana. There are rules in place the tourist must follow as they approach these predators. Otherwise, the tourist would have the freedom to act in any way he or she chooses in this situation. Unfortunately, so would the lions.
Trading the gaps are the one moment of the trading day where everyone has to show their poker hand, and this creates the single biggest advantage for the short-term trader. Understanding the psychology behind the gaps is paramount to playing them successfully on a daily basis. Trading the gaps are so powerful that many traders make a nice living playing these set-ups alone.
The key is to know how they work and to develop a solid methodology and set of rules to trade them. After reading this article, the serious trader will have a better foundation for a plan to trade the markets successfully on a full-time basis: a proven set-up to play, markets that best fit that set-up, and a plan of action to maximize the play. That is pretty much all the trader needs to survive and thrive in this greatest of professions.
Is Trading the Gaps Right for You?
Trading the gaps is a great strategy to learn, but if it didn’t resonate with you then there is nothing to be ashamed of, not every trading strategy is meant for every trader. That’s why Simpler Trading has many trading rooms that traders can enjoy and trade within their comfort level. For instance, if you are interested in learning options, the Options Trading Room is there for you. Traders can trade with a community led by an expert that can help and mentor you through the world of options.