I recently had the opportunity to sit down to dinner with Scott Andrews from MastertheGap.com, and at the end of the dinner I honestly said to myself, this guy has got something here. Now there's a lot of "gap" research and insight out there, but Scott takes it to a different level. So if you have some time, please read his article, fire away with the comments, and visit his site MastertheGap.com.
If you are looking to become a serious trader, there are two critical questions that you must answer; “What is my primary trade setup?” and “What is my edge?”
When I started out, it seemed like every book, every website, and every trader touted a different setup – each with its own merits. But I knew that I needed a trade that fit “me” and my trading personality. After lots of searching and introspection I settled on fading (i.e. trading the opposite direction of) the opening gap in the indices (e.g. S&P 500, Dow 30, Nasdaq 100, Russell 2000). Not only do opening gaps occur daily and offer significant profit opportunity,but they have an inherent directional bias. In fact, over 70% of gaps will retrace from their opening price back to the prior session closing price that very same day, often in the first hour of trading.
Further, the gap fade setup eliminates the stress and frustration of selecting the right entry and exit points – a challenging dilemma for many traders and methodologies. In my early days, it seemed that I often waited too long and missed the entire move, or worse, entered too early and got stopped out right before it would reverse and hit my target.
When I was fortunate enough to catch a winning trade, the next obstacle would often get me: when to exit? Being the competitive person that I am, I prefer trade setups that have a high winning percentage. So, I'd routinely panic at the first sign of a potential reversal and take profits well ahead of my originally planned target. For visual purposes, it was akin to eating like a mouse (un-fulfilling) and defecating like an elephant (painful!). The good news for me was that by focusing on the opening gap, I could minimize execution risks by entering at the open and simply targeting the gap fill area i.e. the prior day's closing price.
But if I had to pick one single reason the opening gap fade setup is perfect for me, it is this: I can trade it with the same advantage of a professional card counter in Las Vegas: a mathematical edge. Time and time again in my early days of trading, I found myself cherry-picking setups and invariably selecting most of the losers and missing many of the easy winners. It was an endlessly frustrating experience to put it mildly, and I knew the problem was that I did not have any data that I trusted supporting my setups. However, by focusing on fading the gap, I was able to back-test and calculate historical probabilities for my trades, For my trading style, developing a mathematical edge was critical to my success in sticking with a setup.
My first research breakthrough was in recognizing that gap selection was the “door” to making profits and the “key” to that door was to focus on the location of the opening price. Using the prior day's direction (up or down) and the open, high, low, and closing prices, I created ten “zones” and each provides tremendous insight into the probability of a gap filling or not. View my Gap Zone Map. My selection strategy has evolved over the years to include market conditions, patterns and seasonality, but zones remain the foundation of my gap fade selection criteria.
So why do zones work? If you think about it, they inherently incorporate :
• proven support and resistance levels
• short term trend
• gap size
• trader psychology
Together these four elements combine to create a wide range of gap fade scenarios that vary from high probability to high risk. Since opening gaps in general have a strong tendency to trade back to the prior day's closing price, the name of the game is not trying to catch all of the winners but rather to avoid most of the losers, and that is what zones do very well.
View the historical probabilities of a wining gap fade (i.e. gap fill or finished the day profitably) for each zone in the S&P 500 since 1998. Note: these probabilities are for the S&P 500 e-mini futures, but the SPY exchange traded fund shows similar results, in fact all of the US indices show comparable historical probabilities.
So why do you think gaps in the U-L zone (bottom right of the Gap Zone Map) show such a low historical win rate (54%)? I believe it's because gaps opening in this zone are catching traders positioned to the long side off guard, triggering many sell stops in the process. Plus, such an obvious reversal from the prior day surely attracts new short sellers who want to jump on board the beginning of a new potential trend. I've nicknamed this zone the “BLUD” zone for obvious reasons, plus it's easy to remember: “Below the Low of an Up Day.” If you do nothing else but avoid fading these gaps, you’ll be a better gap trader in the long run.
Whether you trade the opening gap as a setup or just want to improve the timing of your swing trade entries and exits, you will do a better job, if you pay attention to the zone next time. Idea: try tracking the opening location of your favorite trading instrument and it’s frequency of gap fill. The results may surprise you and may help you filter your other trades too. And if you are looking for a new setup with a well-defined edge, check out the opening gaps in the indices.
Good trading and good gapping!
P.S. I post free daily “gap wrap” videos in the Free Info Section of our home page at MastertheGap.com. If you are interested in some educational videos on the opening gap on the INO.TV website, please let me know by commenting below. Thanks!