Why Fading The Opening Gap Is The Ideal Setup for Me

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.

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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!
Scott Andrews
MastertheGap.com

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!

32 thoughts on “Why Fading The Opening Gap Is The Ideal Setup for Me

  1. Scott, How is Profit Factor calculated?

    Also is the reason that Average Win/Loss Ratio is 0.91 not 1.00 at 100% of gap Stop size the fact that at day end you close out your position (if not previously filled) at some value other than at gap or stop?

    Thanks

    1. Profit factor (PF) is the aggregate profits (from winners) / aggregate losses (from loser). A PF of 1.0 means that it was historically a breakeven strategy and a waste of time to trade.

      You are correct. The profit factor is a little less than 1.0 when using a stop equal to the size of the gap since a small percentage of gap fades will hit neither the stop nor the gap fill area (prior day's closing price) and will be closed at end of day for a profit smaller than the size of the gap, thus diminishing the average size winner a little.

      Good observation and question!

  2. On other comment: your key insight here is that win rate is of little value and I agree. It's all about profit expectancy and I share this data too at my site in the form of historical "profit factors" (ratio of aggregate profits from wins / aggregate losses from the losers) to aid in decision-making.

  3. Frank - you are absolutely correct. I have done lots of research in this area.

    Using an end of day stop, the losses from the ~30% of the losing gap fades is almost exactly equal to the profits from the ~70% that are winners. The markets are indeed efficient.

    And per my comment and link above in response to Ron D's last comment, using a stop does not improve profitability, it just changes the win rate. Pardon the plug, but in my book, "Understanding Gaps" (available at Traderspress.com)I discuss the stop size dilemma and explain that the solution (in my opinion) is to focus on gap SELECTION.

    Zones are the foundation to my gap trade selection process. I also consider market conditions, seasonality and patterns. I post daily probabilities for each zone based upon these factors for the US indices at my web site. Or you can crunch the numbers yourself and the revelations will become more apparent.

    1. Thanks, you're making me a believer. One more question, is there any variation between financial indices?

      1. Frank, the S&P 500 and Dow 30 are highly correlated. The Nasdaq 100 and Russell 2000 are too, but less so. The majority of the time, the gaps in these 4 US indices will either all fill or none will fill on a given day.

        They are all generally good gap fading markets since they are diversified indices. The Russell moves the most and provide the most profit opportunity these days, but it requires a bigger stop too.

        I mostly trade the S&P 500, but will dabble in the other indices on occasion. In general, I prefer to focus on a market, but it's really a personal thing and all are good trading vehicles.

  4. The "fill the gap" statistics are highly publicized but I've never seen the other side of the coin which is: when you don't fill the gap how much do you loose?. Obviously, to exaggerate, even if you fill the gap 70% of the time, if you loose 5X your wins each time you loose this is a bad proposition.

    Putting in stops can cut down the average amount of lose but will also reduce the percentage of wins as you'll be stopped out of some potentially winning trades.

    Do you have any statistics Scott (or anyone) on either the average amount of loss assuming no stops with the trade closed at either gap fill or at end of day if gap not filled, or with specified stops (along with revised win percentage)? Thanks,

    Frank

  5. Skip, your daily bars will show the gaps depending upon how you have your charts set up and/or your broker.

    For example, with TradeStation the SPY daily charts do show overnight gaps since they default to the cash session hours of 8:30 am - 15:00 pm CT. (Note: the SPY actually trades until 15:15 CT, but it's daily settlement closing price is based upon the 15:00 CT cash closing price.)

    Also, for futures with Tradestation, simply append ".D" to the end of a symbol to enable your charts to show the overnight gaps.

    Regarding breakaway/runaway gaps, the historical average for gap fills is about 70-75%. So, that means about 1 gap per week, sometimes 2, will not fill and this past week was indeed fairly typical.

  6. Me again Scott....I assume that your "Gap Zone Map" on your site is in reference to where the gap opens in relation to the map zones, is this correct?....Also, which exit strategy do you like, or do you just use a completed gap fade as your target?....RE: your 30% of a 5 day ATR for a stop, it seems to produce many whipsaws in my backtesting. Could 30% be a bit tight?.......Thanks again.....Ron D

    1. Ron,

      The Gap Zone Map simply shows the historical probabilities based upon WHERE the gap opens in relation to the prior day's Open, High, Low and Close.

      I rarely scale out prior to gap fill (e.g. 1/2 gap fill) since this generally only reduces profits while not increasing the win rate much. At a minimum, I target the gap fill area and frequently will hold some of the position for an extended target (i.e. beyond the gap fill area). Doing so dramatically increases the average size win while only reducing the win rate a little. The key of course is understanding when the setup favors an extended target or not, and I spend a lot of time and effort studying this.

      I have found that there is no single "magic" number for stop sizing. Depending upon the market and the then current conditions, 30% may be too tight or too big. The good (and bad) news is that the size of your stop is not going to make a big difference on your overall profitability - it primarily affects the win rate.

      Here's a blog post that shows my research on this topic:
      http://www.thegapguy.com/blog/stops-are-overrated.html

      Scott

  7. This week, three gaps were filled, one partial around 75%, and one runaway gap. Friday's was a small gap that was filled within 3 minutes.

    I also noticed that daily bars do not show if a gap was filled correctly since it has the pricing data of the normal trading hours plus that day's extend trading hours' pricing included. Wednesday's daily bar showed that the opening gap was filled which was not during normal trading hours...gap was filled after hours trading. So I use intra-day bars in my charts to check for gap fills or not.

    There seems to be a runaway gap at least once a week. Is that the norm?

    I trade the gaps with front month DITM SPY options, usually they are 5 cent spread but sometimes 10 cents. It moves almost dime for dime of the SPY with less capital outlay.

  8. Hi Barrie - thanks so much for the nice words.

    I know several folks are trading our daily probabilities for the ETFs using the leveraged funds like you mention. I have no direct experience though, but I know of no reason that they shouldn't correlate closely enough to work.

    One other thought: You can trade futures with your IRA if you set up a relationship with the Millennium Trust Company at http://www.mtrustcompany.com/. That's who Tradestation recommends.

    Go to our website and contact me and I'll ask members in our discussion forum for some direct feedback on this topic. We have a pretty helpful community of gappers.

  9. Good post. I get something new every time you "speak" (live or virtual), it seems. You were one of two presenters at the NYC Traders Expo (Feb. 09) from which I learned a great deal. I was a new trader, and the concept of trading gaps, with stats, fascinated me pretty much immediately.

    My only problem is that I'm trading inside an IRA, so not having access to margin means I'm bumping up against settlement rules when I try to fade gaps in ETFs. I do follow all the info you provide for free, but hesitate to spend for the monthly program because I do have such limitations on funding trades. I've found I have to take on size in an ETF to get any kind of reasonable profit, which I define as at least $100 per trade after costs. And if I take on size, it's three days before I can use those funds again. Arrggh.

    My question: can I used the levered ETFs for fading, like SDS, (more bang for buck), or does the never-quite-precise leverage factor throw a crowbar into the stats?

    Thank you so much, Scott! Good trading to you.

    Barrie
    BarrieAbalard on Twitter

    1. Hi Barrie.....I too trade gaps in my IRA, and to mitigate the 3 day rule I just divide my IRA into three different BR's, that way usually one trade will be clearing while I'm executing another....And I do use SH and DOG in lieu of getting short in an IRA....The gap trade usually lasts no more than 2-4 days at the most so the leverage factor usually doesn't take much toll in that time frame, or so it seems.....I do prefer SH to SDS as it isn't as leveraged....GL to you in your trading......Ron D out here in Bullhead City AZ.....

  10. I would very much like you to give some further insight in trading gaps and using them to enter/leave a trade.

  11. When the indicies gap up like that the option becomes quite expensive. Is there enough of a movement to still make a decent profit ? Although most all main index options trade in $1 strikes and penny spreads.

    1. Joe, you are correct. It is very difficult to trade most gaps with options. Too much premium, spread and lag to deal with for all but the larger gaps and those generally have a lower probability of filling. I trade the gaps using the e-mini futures which are highly liquid, very little slippage and trade very cleanly. ETFs like the SPY, QQQQ, IWM etc work well too.

  12. Is this article for Day trading?
    There was barely any content in the first half of the article.
    The author doesn't even have the courtesy to define whats a Gap in the first place.

    1. Thanks for the feedback Joe - sorry the first half was of little value for you. And yes, I trade the opening gap as a day trade. I never hold a gap trade that has not achieved it's target over night. Reason: about 75% of unfilled gaps in the indices will NOT fill the next day either.

      For those just starting out on their trading journey there is "gold" in the first part. Meaning: unless you are trading a market and setup that fits your personality, beliefs, and objectives, you have little chance of long term success in my humble opinion.

      And Joe you are right, I did a poor job of defining a gap. The most common definition of a “gap” is the difference between an instrument’s opening price and its prior day (or session) closing price. This difference shows up visually on a technical price chart as an open space or “gap.” (Note: some traders define a gap as the difference between the prior day high or low and the next day’s opening price.) For me, I use the open and close of the regular trading hours (i.e. pit session when most volume is transacted) for the S&P 500 futures: 8:30am - 16:15 pm CT

      I have more definitions that may assist you in the "Gappers Glossary" which is on the left nav bar of the MasterTheGap.com site.

      Scott

  13. Interesting theory! I would like to about the educational videos on this subject.

    Thanks

  14. Great article Scott....I've been trading gaps for awhile now. Made many mistakes in the beginning but am ironing it out as of late...I like to peg my (long) entry of a down gap to yesterdays low....It creates a bit more slippage but also yields a much higher high probability trade, and high probability is what floats my boat.....And yes, I'd love to see more of your gap educational articles/videos posted on INO.....Thanks again.....Ron D

    1. Thanks Ron - I too like the higher probability setups - often does require a bigger stop and/or limiting your trading to only those gaps that occur within the tips of the prior day's range (i.e. between the high and the low).

      I've got some free research that you may find of interest on stops, targets and variety of other topics at my free blog site too: http://www.thegapguy.com

      Scott

  15. I have watched some of the gap openings in many markets and have found this to be a high percentage win trade so have kept doing it. Study it and you will also know exactly where to place stops.

    1. Dane,

      For what it's worth my standard size stop is 30% of the 5 day ATR (average true range). This seems to work well for most markets - especially when there is not an obvious place for the stop.

      The more volatile markets may need a little bigger stop 35-40% of the 5 day ATR, while less volatile markets may need just 25%.

      Good gapping!
      Scott

  16. Awesome post!

    This theory is very intriguing. I would love to see some educational videos on INO's site.

    Thanks for the information.

    Regards,

    Mitch Hamilton

  17. I would welcome educ. on INO.TV. Thank you.

    Like everyone else I see gaps daily, and like many, I know that they are inclined to retrace 50% or so to fill in, before continuing their trend.
    But, I notice! And that's why I know essentially that you are on track. I'll just have to learn "how" to profit from the pattern.

  18. Welcome Scott,

    Great article.

    I trade FX and Commodities only.

    Does this concept have applicability in these markets?

    Best wishes,

    Patrick Keith

    1. Thanks Patrick - glad you enjoyed it.

      I've never tested FX, but have tested a variety of commodities. Many tend to trend more than the equity indices, but there are definitely some good setups that can be faded among them too.

      The concept of "zones" based upon the OHLC and prior day direction is a useful structure for segmenting trades of all types I believe (not just the opening gap) and for most markets too.

      Take care,
      Scott

      1. True and I don't trade the FX. That said, you might want to consider this: the index futures markets trade 23:45 hour per day. So what I do is to simply create custom sessions around the period of the day with the most market volume. For the index futures this is from 8:30 - 3:15 pm CT (in line with with pit sessions in Chicago and cash sessions in New York).

        The concept being that low volume price action often fails to hold and will frequently be tested with volume.

        Again, I am not sure this idea holds merit with the FX, but certainly with a look.

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