Trading the Gap

There are a number of common theories and misconceptions about opening gaps and how to trade them. Trader Jack himself has always maintained that it is wise to 'mind the gap', and strongly recommends not dashing madly after a market powering away unless you REALLY know what you are doing. We therefore felt it might be useful to investigate common gap trading ideas and comment on them for our readers at www.traders101.com .

Here are the results of a study on the Nasdaq, including every gap in the last 15 years. At first glance, the Trader Jack rule 'never chase the gap' looks like a good rule - over 70% of gaps get filled on the day they occur, i.e. the the market falls back to the previous day's close before the end of the session. Also worth noting - the average size of a gap on the Naz (both long and short) is just over 1.16%. As you might expect, small gaps get filled more often than big gaps - there is 'less work to do' for the market to reverse a small gap.

Larger gaps have a tendency to stay open more than small gaps - for example, a gap that is twice as large as the average gap (2.33%) will typically remain open over 60% during the session (although they may get closed again the next day). Likewise, a gap 3 times the size of an average gap will remain open almost 65% of the time on the day. At the top of the scale, gaps that are 3.5% larger than an average gap remain unfilled almost 90% of the time on the day they occur. They may only get filled 21% of the time during the week, too!

This data tends to suggest that a reasonable gap trading strategy might involve trading against (or 'fading') small and average sized gaps, and to 'go with' a large gap. So how does one implement such a system? Let's take a closer look.

Given that we might want to consider fading a small gap, we can give a it a bit of 'room' to develop before committing to a trade - it is, after all, likely to come back. The average trader seems to prefer watching the first hour (the time when allegedly the 'silly' money comes and goes), and then deciding on a trade. Within this first hour, a small gap will often have 'settled', or even begun the process of falling back towards the previous close. Whatever the situation, a 'range' will have been defined by that first hour's action - generally the strategy then would be to go long above that range, and short below it.

With this in mind, it is helpful to consider the trading on the basis of the '4 types' of gap that are generally supposed to exist. The first of these is the 'Full Gap Up'. This happens if the opening price is greater than yesterday's high price - A big jump, in other words. Likewise, a 'Full Gap Down' is when the opening price is less than yesterday's low. A 'Partial Gap Up', on the other hand, happens when today's opening price is higher than yesterday's close, but NOT higher than yesterday's high. In the same way, a 'Partial Gap Down' is when the opening price is below yesterday's close, but NOT below yesterday's low.

These 4 gap types each have a long and short trading signal, giving us 8 gap trading strategies in total. All are based on a gap trading strategy in which you wait 1 hour after the market open so a trading range can be established. Trading before that time is up is possible, although it involves more risk. As always, sensible stoploss methods to minimize losses if things go wrong are mandatory!

Full Gap Up

The Long trade - after 10:30 am, you know where the high of the first hour has been. You then set a long (buy) stop 2 ticks above that high. ALWAYS use a trailing stop to protect yourself if the trade goes live.

The Short trade - if the move has faltered, set a short stop 2 ticks below the low formed in the first hour's trading.

Full Gap Down

The Long trade - set a long stop 2 ticks above yesterday's low. If the stock turns around, this will put you in the right direction for the dead cat bounce.

The Short trade - set a short stop 2 ticks below the low made in the first hour.

Partial Gap Up

The Long trade - set a long stop 2 ticks above the high made in the first hour.

The Short trade - set a short stop 2 ticks below the low set by the first hour of trading.

Partial Gap Down

The Long trade - set a buy stop 2 ticks above the high formed by the first hour of trading.

The Short trade - set a short stop 2 ticks less than the low made in the 1st hour of trading.

Confirmation - breaking of support or resistance levels provides confirmations the move is valid.