Article: Trading the Opening Gap (no charts)
The Opening Gap and mini Dow: First and Best Trade of the Day
By John Carter, www.tradethemarkets.com
Trading the markets offers perks that no other career can match:
1. Financial Freedom
2. Location Freedom
3. Boss Freedom
4. Employee Freedom
5. Wardrobe Freedom
6. Overhead Freedom
7. Barriers to Entry Freedom
8. Schedule Freedom
Although these perks still can't protect the trader from his or her own mother-in-law and teenage children, they are still extremely appealing and impossible to duplicate in any other profession. Reasons for wanting to trade full or part time can range from wanting a career change, wanting to run your own business, or wanting to be a stay at home mom. This is a "job" that offers the chance to make a very, very nice living. It can be done from anywhere that has reliable Internet access. There are no bosses giving inane, absurd, ever-changing contradictory orders. There is the choice of whether or not to hire an assistant. Trading in a robe or nothing at all is perfectly fine (with an assistant, however, that aspect does change). Offices and overhead are not necessary. Long years wasted in college getting an advanced degree are not required. Finally, a trader can choose his or her own schedule. Some examples of schedules from successful traders I work with include: Trading actively during October through April and then taking the other 5 months off; trading the first two hours of each day only; trading Tuesdays through Thursdays only; and trading until they make 50% on their capital and then taking the rest of the year off. Sounds great, doesn't it? With so much to offer, it is no wonder that tens of thousands of people toss their hat into the ring, trying to make a go at this most appealing of professions.
However, a quick look at a stack of 1099s going out of a brokerage house reveal that over 90% of all people who actively trade the markets fail. The reason for this failure is simple and can be summed up in one word: GREED .
I've watched thousands of traders go through this process, and it is always the same. Background, education, status in society and amount of money do not matter at all. A trader starts off with good intentions, of course. And as the saying goes, "The road to hell is paved with good intentions."
Let's call our trader Ted. Ted does some research and decides that he wants to make $500 a day trading mini-sized futures on a $25,000 account. This is a very reasonable goal for the active trader, equating into roughly $120,000 a year. Ted is going along for the first few weeks, and things are going fine. But then one day he makes $750 and suddenly $500 isn't enough any longer. Another month goes by and suddenly $1200 a day sounds more appealing, so Ted "steps up" his trading in order to accommodate this goal-which usually means trading bigger and more often. Suddenly this isn't enough because $1500 sounds more appealing and more exciting. Ted, like a mouse going after the smell of fresh peanut butter on a newly laid trap, is setting himself up to get killed.
In trading, it isn't the tortoise or hare that wins the race, and it certainly isn't the pig. It is the sparrow who darts in, grabs a mouthful of seeds, and is off before the neighborhood cat can pounce. That said, it is important to realize that it is not just any sparrow who will be the winner in the end. It is the sparrow with a pre-determined plan that specifies the number of seeds he will eat each day that ultimately survives. The moment the sparrow gets over confident and tries to gorge himself, he is dead. The cat, patiently waiting in wings for her moment to pounce, will snatch the physically and mentally gloated sparrow in a heartbeat. By succumbing to greed, Ted has set himself up both physically and mentally to be taken apart by the 10% of traders who routinely make money.
The key to trading, then, is not background dependent, but mental training. On our site we list our "40 Bits of Wisdom" which we require all of our traders to read and understand. This helps to put the trader in the right frame of mind before trading the markets; many of our traders read through this list before each trading day. This is the most important aspect of trading-preparing the mind. Why? Because the markets are designed to keep as many people as possible from making money. This is how they move on a day to day basis. If everyone were content, the markets would never move, as nobody would be buying or selling. Big moves are generally made by forced margin calls.
In the short term, market movement has nothing to do with valuations or economic outlook . It has everything to do with current collective trader positions. This is why people who are "perma-bears" have been getting their hats handed to them since the March 2003 lows. At some point the markets reach a point where there are too many people who are long, and the market reverses, generating forced margin calls until that avenue of supply has been exhausted. In a similar vein, at a certain time the markets will reach a point where there are too many shares being held short, and the markets will reverse course, igniting forced margin calls until the amateur short supply has been depleted. It's a very cruel, yet very efficient process. The key for the individual trader, of course, is staying on the path of least resistance, and not holding onto any idiotic notion that the market has to move in a certain direction based on an individual's feelings of bullishness or bearishness. Knowing this, the key to being in that smaller stack of positive 1099s each year is to head into each trading day with the following ammunition:
1. A professional trading mindset and mental edge.
2. A handful of proven setups to play.
3. A market to trade that fits an individual trader's personality.
4. A plan of action for daily, weekly and monthly P&L swings.
5. Never getting into a situation where your broker is forced to liquidate your holdings.
These are critical steps and without them a trader is doomed to failure. I could write a couple of books on these subjects, but for the sake of this article, let's boil this down to the brass tacks: Traders who want to survive at this game have to understand gaps, and taking advantage of gaps using the CBOT® mini-sized DowSM contracts is one of the best ways to stay profitable.
Each day in the market there is one opportunity that represents the lowest risk trade available, and that is the opening gap. Gaps occur when the next day's regular session opening price is greater or lower than the previous day's regular session close, creating a "gap" in price levels on the charts. Gaps occur in many markets, but the key to making money on gaps is four-fold:
1. Knowing whether the gap is a break away or a fade.
2. Knowing how much time it needs to fill its gap.
3. Knowing how much of your equity to risk.
4. Playing gaps in the market most suited to your personality.
Before we take a look at how I play the gaps every day, I want to first take a look at the best market to utilize for these plays. Markets are a reflection of the traders who trade them. The emini S&Ps are a great market to trade if you are 22 years old and obtain 30% of your daily nutritional intake from Starbucks. This is a market made up of traders who are hyper-reactive, with many players trading thousands of contracts a day for quarter point gains. This is the type of intensity that can't last and burns people out. On the flip side, if a trader is more methodical and takes more than half an hour to decide which socks to wear with a pair of gray pants, then trading Exxon-Mobile (XOM) stock is going to be right up their alley.
A happy medium between these two extremes is the CBOT mini-sized Dow futures. They have enough volatility to make intraday trading worthwhile, but at the same time do not experience as many nerve-jolting moves as the S&Ps. In addition, the mini-Dow follows the S&Ps, so a trader does not have to be the first one in to make money. A trader can let the over-caffeinated S&P traders make the first move, and then hop on board via the mini-sized Dow before the train has left the building. This is just one of the reasons why we think the mini-sized Dow is the perfect contract to trade for both new and experienced traders.
Now that we have our market to trade, let's focus on how to maximize gaps in their market for maximum profitability.
In terms of gap plays, it is important to realize that not all gaps are created equal. Gaps are like windows, and like all windows, at some point they are going to be closed. The key, then, is to be able to accurately predict when the day's gap (window) is going to be filled (closed). Many gaps get filled within the first hour of trade. Other gaps tend to linger, only to get filled later in the day. Still others take days or even weeks to get filled. Why is this? To understand what causes this to happen, let's first step back and take a look at what creates opening gaps in the first place.
Gaps are created for these main reasons:
1. To move the market in such a way as to cause the most pain to the greatest amount of traders as possible.
2. To keep as many people possible out of the move.
3. Or, to be used as a fishing expedition for suckers.
4. Reaction to overnight news.
Gaps differ slightly each day they are created, and this is based on a variety of factors. However, there are constants in each opening gap. The biggest gaps happen at key market reversals on the weekly and monthly charts. A perfect example of this is the move off the March 12, 2003 lows, when the DowSM hit a low of 7371 intraday and reversed to close at 7483. The next day the markets gapped open at 7610 and have never looked back, leaving an opening gap at 7483 that will get filled at a future date . The point is that the markets made a huge move overnight, leaving behind all participants who were not already long, and of course inflicting as much pain as possible on traders who were short. Traders who were flat and wanted to get long had to spend day after day watching the markets move higher, as there were not any decent pullbacks.
In these instances, lasting rallies occur as people who are flat can't take the pain of not being in the move any longer. They capitulate and buy in. Fuel is added by disbelieving shorts as they are forced out of their positions on margin calls. These types of gaps typically occur only once or twice a year, and kick off the most powerful market moves.
Much more common are gaps that are news reactions and fishing expeditions. These are smaller in nature and can be faded regularly, as long as a few key factors are in place. Let's take a look at some recent examples:
The chart below details a 5-minute regular session chart of the mini-sized Dow futures. (For gap plays, I keep a regular session chart opened next to a Globex session chart so that I can clearly see the gaps, as well as the Globex highs and lows). This is perfect example of what we call the "psyche-gap." Many traders have a system of buying or selling the 30 minute highs and lows. Professionals know this and take advantage of this setup by initiating enough momentum to get the markets started on a short-term stop run, flooding the market with stop orders. Once the stops are done triggering, the markets lose momentum and begin moving back in the opposite direction.
On the morning of July 24, 2003, the Dow gapped up 58 points. I utilize a checklist created the night before when playing gaps. On my checklist, there are 20 key areas of the market that are covered each evening, right up to the opening bell. Going over this list, I note that the pre-market volume is low, the put/call ratio closed under 0.75 the day before, and the Arms Index was not in an oversold zone. Based on this, and according to the rest of the points on my checklist, I know that this gap has an 80% chance of filling sometime today.
Because of the economic data coming out at 10:00AM, I also know that it most likely will not happen in the first half hour of trade. Therefore I accumulated a short position in three stages, starting off with 1/3 size at the opening during the first 5 minutes of trade. For the purposes of simplicity, I will refer to a full position for the rest of this article as 9 contracts. A 1/3 lot is 3 contracts, a 2/3 lot is 6 contracts, and so forth. In addition, for full positions I trade 1 contract for each $11,100 in my account. Although you can trade a mini-Dow contract with only $2,000 in your account, part of my trading plan includes limiting my risk by limiting how much exposure I have to the markets at any given time. For the purposes of this article, then, I am trading 9 contracts on a $100,000 account. This same ratio can be duplicated based on your own account size.
I set a 1:1 1/2 risk reward ratio (risking 1 1/2 points to make 1 point), risking 87 points to make 58 points. I use different risk reward ratios based on the setup, but they are generally 1:1 1/2 to 1:2 risk reward ratios. (Most amateurs use 3:1 risk reward ratios, risking 1 point to get 3 points, and then they wonder why they get stopped out on every trade just before the market turns). They key, of course, is to only play setups that have a greater than 80% chance of winning.
Okay, let's take a look at the chart below:
I shorted 3 contracts near the open at 9233, with a stop at 9320 and a target of 9175. The markets drift down in the first 15 minutes, but do not fill the gap. As the report nears, the markets firm on nervous short covering, then pop higher on the report. I short another 3 contracts on this reaction, keeping the same original stop of 9291 on both lots. I then add my last 3 contracts when the markets break back below the open at 9233. By 10:40 a.m. Eastern I have a full 9-lot short of mini-sized 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 the market.
I will execute some plays in the bonds if they set up, or do some moving average crossover scalps on the S&Ps, but bottom line is that I do not mess around with my gap play. I do not trail my stop. I will either get out on my stop or on my target.
As you can see on the chart above, the markets sold off and at around 2:15 p.m. Eastern my target was hit for a little over 60 points total. This is $300 per contract, or a total of $2700 on my 9 contract position (60 Mini-Dow Points x $5 per point x 9 contracts). If my stop had been hit, I would have lost approximately $435 per contract, or a total of $3915. I am comfortable with that because I know that 80% of the time this trade will work out in my favor. Had I used 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 setup, but one is losing money while the other is making money. Let's take a look at another play:
On the chart above we had an opening gap of just +24 points, which is modest. Looking over my checklist, I see that we had some selling the day before and some key oscillator sell side crossovers. Because of this and because the gap is under 50 points, I start off with a full 9-lot position right away, using a 1:2 risk reward ratio which means a stop at 9301 and a target at 9229. The gap is filled in 20 minutes and the trade is done. These are my favorite gaps (fades in the opposite direction of the shorter term trend) and I love to jump on them whenever possible. For these 20 minutes of work I am paid $1080. (Another strategy we use is to scale out of the trade, getting out of 1/3 5 points in front of the gap, 1/3 at the gap, and THEN trail a stop on the remaining 3rd in case we get a breakaway move through the gap level).
The next gap example is the kind that kills amateur traders who are using their tight 3:1 risk reward ratios. We get a nice opening gap of +77 points. Because this is over 50 points, I only start off shorting 3 contracts at the open. Utilizing my checklist, I see that we have economic data coming out, a neutral Arms Index, a slightly bearish put/call and a number of other factors. The markets sell off a bit in the first 15 minutes, then rally and break new highs into the number. I short a 2nd lot of 3 contracts on the break of new highs. The number hits and the markets sell off.
Initially I am expecting that the markets will then quickly fill the gap on my 6-lot position, which is fine with me. But the markets stabilize and then start to rally, eventually breaking to new highs. When we get a +1000 tick reading, I add my final 3 contracts. I now have a full position, with a stop at 9371 and a target at 9256. The markets spent the bulk of the afternoon session trading near the highs, getting as high as 9343, just 29 points from my stop. However, having traded gaps literally hundreds of time and knowing their outcomes based on my checklist, I did not bail out or tweak this position. Either I would get taken out at my stop, or my target would get filled. Let's take a look at the outcome:
As you can see, later in the session the markets rolled over, closing weak, but still positive on the day and not having filled the gap. I kept the position overnight with the same parameters and my target was hit quickly the next day. Why did I hang onto this trade through the day and overnight? Isn't this being greedy? No. It is the sparrow sticking to a pre-determined plan, knowing that the chances for success are 80%. I'm out with healthy gains of approximately 77 points, or $3465.
On the chart below there are two back to back examples, a loser and a winner. On the first gap we opened down on light volume and the gap was minor, only -19 points. I took a full position at the open and set up my stop at 9094. This stop was quickly taken out for a loss of 29 points, or $145 per contract ($1305). The stop is 1:1 1/2 because it is a continuation of the previous days move. I am willing to give counter trend moves more room and will give them a 1:2 risk reward ratio, because they have a higher success rate of filling their gaps the very same day.
Based on my studies that gaps under or over 50 points that occur on low pre-market volume have an 85% chance of filling its gap that same day, I watched for a 9/18 simple period moving average upside crossover on the 5 minute charts during the doldrums (see Profits and Professionalism as a State of Mind by Michael Kirkfield on the CBOT site for more information about this strategy) using the gap fill as my target. This signal initiated a full long position near 9060, and the gap was then filled later in the day for an 82 point gain, or $410 per contract, leaving me net +$265 per contract on the day (+2385). For moving average crossover setups related specifically to gaps, I used a 50 point stop and I do not trail it, with the gap fill as my target.
What is important to note here is that even though my initial gap play failed, the gap play was not done for the day, and I took my next setup based on the market filling its gap later in the day. Let's take a look at the chart below (The trade just described is the 8/1 gap on the left):
The second example is my favorite type of gap. The gap occurs and is filled within 15 minutes. This time it was only for 10 points, or $50 per contract ($450), but it's a living.
On the chart below we have two examples of "low stress gaps." Again, using my checklist, I take full positions at the open with 1:1 1/2 risk reward ratios, and my targets are hit in the first 15-20 minutes of trade for 25 points ($125 per contract/$1125) and 16 points ($80 per contract/$720) respectively.
Okay, now what about the gap that doesn't fill for a few days? I love it when these "open windows" are out there in the markets because they act as a magnet for price action, eventually sucking prices back to their filling point. On August 18 we gapped up a modest 35 points prior to some economic numbers. I shorted 3 contracts at the open. We rallied, sold off into the numbers, and then shot higher once the numbers were released. I shorted a 2nd 3 contracts as the markets popped to new highs on the numbers. I had a 53 point stop and a 35 point target. I was planning to add the final 3 contracts on a break back through the opening levels. However, that break never materialized and the stop was hit for a loss of $265 per contract on a 2/3 size position, or $1590. Let's take a look at the chart below:
I head into the next trading day knowing there is now an open gap below us that will get filled in the next week or so, based on the intermediate term technical indicators which show the markets in a trading range as opposed to getting ready for a big breakout. The next day we have a modest gap that works out quickly, for $75 per contract ($675).
The day after we get a nice 53 point gap that takes a few hours to fill but offers few headaches, for $265 per contract ($2385). The next day we get a 51 point gap that comes close to our stop but eventually fills the gap for $255 per contract ($2295). Finally on August 22 we get the sucker gap when Intel announces "cautious upside earnings revisions" and this gaps the markets right into key resistance.
I short the gap and am quickly filled for 67 points or $335 per contract ($3015). At this time I am also looking for signs that the market will continue on its downtrend, with the target being the gap left on 8/18. During the afternoon session we get a bear flag consolidation and I take the 9/18 simple moving average crossover as my signal to go short at the top of the current bear flag formation at an average price of 9418. My stop is just above resistance at 9455 and my target is the 8/18 gap of 9313. The market breaks down later in the day, closing near its dead lows. I hold my position over the weekend and Monday morning we quickly fill the gap for a 105 point gain or $525 per contract ($4725).
Gaps happen for many reasons, all of them based on the basic human emotions of fear and greed. A trader who plays gaps must understand trader psychology and know the odds of how specific setups have worked in the past.
The key to playing the gaps is to have a game plan in place before the market opens. I have a 20 point checklist that covers trends on various time frames, put/call readings, key sector technical setups, sentiment readings and a handful of proprietary indicators that I use each day to determine how much to risk and at what risk/reward ratio. Many of these key points are posted each evening in our "Emini & SSF Newsletter" where we set up swing trades in the Mini-Dow Futures.
I've been playing gaps actively since the mid 1990s, and while there are some common traits each gap shares, in reality each gap is a little different than the next. To trade them successfully takes a solid, disciplined trading plan, as well as experience in dealing with gaps under different market conditions. Hopefully this article has given you enough information to begin looking at adding "the gap" to your daily trading plans. I can't imagine having a serious trading plan that does not include a method for playing the gaps.
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. The gaps are so powerful that many traders make a nice living playing these setups alone. The key is to know how they work and to develop a solid business plan and methodology to trade them. After reading this article you should have the foundations for a plan to trade the markets successfully on a full time basis: A proven setup to play, a potential market to fit your personality, and a plan of action and trading parameters. Good luck with your trading.
