Morning Gap
Strategies
| Having trouble with those irritating morning gaps?
You're not alone. Many of us spend hours working on new
setups, only to watch them go up in smoke overnight. But
there's no need to throw out all of your hard work just
yet. You can do a quick analysis, adjust your trading
strategy and get into a good position well after the
crowd pulls the trigger on a gap play. |
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Many traders still place market orders before the open
and walk away. Unfortunately, this is a sucker move that
yields the worst fills imaginable. Take a few extra
minutes to plan your gap entry, and you'll get much
better prices. No, this isn't a daytrading column,
although it will benefit anyone who plays in the
intraday markets. It's for swing traders trying to
fine-tune their entries and get positioned where they
can take home the most money. Here are some strategies
you can use. |
| Stand aside at the open, and use the third-bar swing
to find the best gap entry. This is a dependable
reversal or expansion move on the five-minute chart,
occurring 11 or 12 minutes into the new trading day.
This phenomenon is a relic of the old 15-minute quote
delay. In past years, painting the tape before retail
investors could access stock prices ensured a few extra
pennies for market insiders. Because retailers were the
last "paper" in the door, natural forces would then take
over and trigger reversals or breakouts. Although
real-time market access has grown substantially, this
third-bar swing still shows its face on many days.
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Let the stock draw the first three five-minute bars,
and then use the high and low of this "three-bar range"
as support and resistance levels. A buy signal issues
when price exceeds the high of the three-bar range after
an up gap. A sell signal issues when price exceeds the
low of the three-bar range after a down gap. It's a
simple technique that works like a charm in many cases.
If you use this technique, though, a few caveats are in
order to avoid whipsaws and other market traps. The most
common is a first swing that lasts longer than three
bars. If an obvious range builds in four, five or even
six bars, use those to define your support and
resistance levels. Also consider the higher noise level
in five-minute charts. A breakout that extends only a
tick or two can be easily reversed and trap you in a
sudden loss. So let others take the bait at these
levels, while you find pullbacks and narrow range bars
for trade execution.
Gap location is more important than the gap itself.
Does the opening bar push price into longer-term support
or resistance? A strong up gap may force a stock through
several resistance levels and plant it firmly on top of
new support. Or it can push it straight into an
impenetrable barrier, from which the path of least
resistance is straight down.
Three-bar range support and resistance often need to
complete a testing pattern before they will yield to
higher or lower prices. This comes in the form of a
small cup and handle, or an inverse cup-and-handle
pattern. Simply stated, price reverses the first time it
tries to exceed an old high or low, but succeeds on the
subsequent try.
Price gaps generate other action levels as well. The
most obvious is the support line in an up gap (or
resistance line in a down gap). We'll call these
"reverse break" lines. Violation of the reverse break
can trigger price acceleration toward the gap fill line.
These market mechanics make perfect sense: everyone who
entered a position in the direction of the gap is losing
money once price moves past the reverse break line.
The gap fill line marks support in an up gap and
resistance in a down gap. In other words, the odds favor
a reversal when price reaches it. Paradoxically, this is
a terrible place for swing traders to enter new
positions. The reverse break line will resist price from
re-entering the three-bar range. In fact, price bouncing
like a pinball from the fill line to the reverse break
line and back to the fill line sets off a powerful
trading signal in the opposite direction. It predicts
the demise of the gap and a significant reversal.
The flip side of this reversal is a failure of a failure
signal. In other words, price overcomes resistance at
the reverse break line and retests the high of an up gap
(or low of a down gap). The ability of price to retest
these levels issues a strong signal to take positions in
the direction of the gap.
