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GapTradingTechniques

GapTradingTechniques

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03/18/2014

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Gap Trading Techniques
1.
Morning Reversal Strategy 22. Trading The Overnight Gap 63. Trading The Opening Gap 124. Gap Closer 16
 
F
inding a strategy that back-tests successfully is rare; find-ing one that is reproducible inlive trading is rarer still.The following intraday strategy — theMorning Gap Reversal (MGR) — capital-izes on the major indices’ tendency toretrace toward the prior day’s close eachmorning. It has a high winning percentage tested in both bull and bear conditions —an important characteristic for any short-term strategy — and it is easy to execute.Each morning the opening price of anindex or stock is higher or lower than theprior day’s closing price. This pricechange is called the
morning gap
if it isabove the previous day’s high (an “upgap”) or below the previous day’s low (a“down gap”). However, for simplicity,we will use “gap” to refer to the distance between the previous close and currentopen, regardless of whether or not theopen falls within the previous day’srange (see Figure 1).First, we will analyze the behavior of morning gaps to determine if they pro-vide a logical basis for a trading strategy.
Morning gap statistics
Statistically, price has a very high likeli-hood of filling between 50 and 100 per-cent of the gap between yesterd ay sclose and today’s open during the trad-ing day. Usually, a reversal that fills (orpartially fills) the gap will occur withinthe first 30 minutes of trading (by 10 a.m.ET).T h ree years of back-testing fro m January 1999 to January 2003 on theDow Jones Industrial Average (INDU),S&P500 (SPX) and Nasdaq 100 (NDX)indices was conducted to verify the sta-tistical reliability of the basis for theMGR strategy. The analysis wasdivided into three parts: first, deter-mining the frequency and extent of morning gap reversals; second, find-ing out how quickly morning gapsreversed; and third, identifyingimportant “time markers” withinthe reversal period.Table 1 summarizes the first partof the analysis. The columns showdifferent gap sizes, from 1 to 3 per-cent (positive or negative). The rowsshow what percentage of the gapswere filled, and the cells show howoften they were filled (at some pointduring the trading session).The table shows 85 percent of thegaps between zero and 1 percent insize (positive or negative) closed atleast halfway, and 78 percent of thegaps closed between 90 and 100 per-cent.Although slightly less re l i a b l e ,gaps between 1 and 2 percent (posi-tive or negative) showed a similartendency to be partially retraced or
2www.activetradermag.com
May 2003
• ACTIVE TRADER S&P 500 index-tracking stock (SPY),one-minute
In the first half-hour of the trading session, the market will frequently retrace inthe direction of the previous day’s close.
FIGURE 1 MORNING “GAPS”: REVERTING TO THE CLOSE
Source: Great-Trade by Protrader
88.97 88.92 88.88 88.84 88.80 88.76 88.72 88.68 88.64 88.60 88.56 88.52 88.48 88.44 88.40 88.36 88.32 88.28 88.24 88.20 88.16 88.12 88.08 88.04 88.01
1/2215:4015:4515:5015:551/239:359:409:459:509:5510:0010:0510:10Market open priceGap upPrior day closeReversal
 
Morning
REVERSAL
strategy
TRADING StrategiesBY BRYAN C. BABCOCK AND ARTHUR AGNELLI
Historical tests reveal the tendency of the major stock indices to revert to theprevious day’s closing price in the early minutes of the trading session. Thisstrategy takes its cue from that bit of market behavior.
 
filled. These gaps retraced by at leasthalf 78 percent of the time and retraced between 90 and 100 percent 62 percent of the mornings studied. Gaps in the 2- to3 - p e rcent range were somewhat lesslikely to be filled.Only 14 percent of the gaps (in the“Overall” column) closed between zeroand 9 percent, which includes thosemornings when price immediatelymoved in the opposite direction of thegap closure, creating what is known as a“gap and run.”The second part of the analysisexpl ored how quickly gaps re ve rse d. The gaps typically closed half way (50percent) by 9:55 a.m. Of the gaps thatclosed completely, 67 percent of themdid so in the first 30 minutes of the trad-ing session, and 86 percent closed by theend of the first hour of trading (10:30a.m. ET). The likelihood of additionalclosure declined substantially after thefirst hour of trading. Gaps that were stillopen after 60 minutes closed only 4.5percent of the time. Also, the success ratediminished on days when economicnews was released 30 minutes after themarket open, at 10 a.m. ET.The third portion of the analysis iden-tified important time markers during theg ap- reversal period. Figure 2 (below)shows the typical time markers for gapreversals. Just after the open, the majorindices tended to continue to move in thedirection of theopening price forthe first one to 10minutes. A f terthis initial rally(or sell-off), themarket turnedand began toclose the morn-ing gap. Thisreversal, on aver-age, began sixminutes after theopen, at 9:36 a.m.ET. The typicalreversal wasmaximized at9:53 a.m. ET.An appro x i-mately four-minute countertrend move (or “jig,”which often fakes out traders into cover-ing positions early) typically occurredaround 9:42 a.m. and lasted until approx-imately 9:47 a.m.
Before the bell:Pre-market review process
The first step in trading the MGR is antic-ipating the direction of the openingmove. Usually two hours before the mar-ket opens a reliable gap can be identified by checking the pre-market stock indexutures quotes on CNBC or Bloomberg TV. (Minute by minute pre-market indexutures quotes are also available through the Chicago Mercantile Exchange We bsite, www.cme.com.) Whether these con-tracts are trading up or down in the earlymorning can give you an indication of the possible direction of the stock marketopen. Second, make note of how the futuresare affected in the pre-market by anyeconomic reports released at 8:30 a.m.E T. This will indicate whether thefutures are strengthening or weakeningin pre-market trading. Make a finalcheck of the futures at 9:10 a.m. (20 min-utes prior to the market open).
ACTIVE TRADER •
May 2003
www.activetradermag.com3
Morning open — up gapMorning peak on average9:36 a.m. EST
The primary time “milestones” in early trading show theretracement to the previous close typically maximizesaround 9:53 a.m.
FIGURE 2A MORNING UP-GAP TIME MARKERS
The time markers for the typical down gap are the sameas those for up gaps.
FIGURE 2B MORNING DOWN-GAP TIME MARKERS
Prior dayclosing pricePrior dayclosing priceMorning open — down gapTrade is maximized9:53 a.m.Trade ismaximized9:53 a.m.Price “jig” —usually9:42-9:47 a.m.Price “jig” — usually9:42-9:47 a.m.Morning bottomon average9:36 a.m. ESTGap size% of gap closed+/-1%+/-1 to +/-2%+/-2 to +/-3%Overall0-9
1281914
10-19
0252
20-29
1652
30-39
1462
40-49
1251
50-59
2521
60-69
1742
70-79
2142
80-89
2322
90-100
78624872
50%
85786079
The columns show morning gaps of different sizes.The rows indicate how much of the gaps were filled.
TABLE 1 MORNING GAP ANALYSIS

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