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Gap Trading Techniques

1. Morning Reversal Strategy 2

2. Trading The Overnight Gap 6

3. Trading The Opening Gap 12

4. Gap Closer 16
TRADING Strategies

Morning REVERSAL strategy


Historical tests reveal the tendency of the major stock indices to revert to the
previous day’s closing price in the early minutes of the trading session. This
strategy takes its cue from that bit of market behavior.
BY BRYAN C. BABCOCK AND ARTHUR AGNELLI

F inding a strategy that back-


tests successfully is rare; find-
ing one that is reproducible in
live trading is rarer still.
The following intraday strategy — the
Morning Gap Reversal (MGR) — capital-
izes on the major indices’ tendency to
prior day’s closing price. This price
change is called the morning gap if it is
above the previous day’s high (an “up
gap”) 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 current
Morning gap statistics
Statistically, price has a very high likeli-
hood of filling between 50 and 100 per-
cent of the gap between yesterday’s
close and today’s open during the trad-
ing day. Usually, a reversal that fills (or
partially fills) the gap will occur within
retrace toward the prior day’s close each open, regardless of whether or not the the first 30 minutes of trading (by 10 a.m.
morning. It has a high winning percentage open falls within the previous day’s ET).
tested in both bull and bear conditions — range (see Figure 1). Three years of back-testing from
an important characteristic for any short- First, we will analyze the behavior of January 1999 to January 2003 on the
term strategy — and it is easy to execute. morning gaps to determine if they pro- Dow Jones Industrial Average (INDU),
Each morning the opening price of an vide a logical basis for a trading strategy.
S&P 500 (SPX) and Nasdaq 100 (NDX)
index or stock is higher or lower than the indices was conducted to verify the sta-
tistical reliability of the basis for the
FIGURE 1 MORNING “GAPS”: REVERTING TO THE CLOSE MGR strategy. The analysis was
divided into three parts: first, deter-
In the first half-hour of the trading session, the market will frequently retrace in mining the frequency and extent of
the direction of the previous day’s close. morning gap reversals; second, find-
ing out how quickly morning gaps
S&P 500 index-tracking stock (SPY), 88.97
one-minute reversed; and third, identifying
88.92
88.88
important “time markers” within
88.84 the reversal period.
88.80 Table 1 summarizes the first part
88.76 of the analysis. The columns show
Market open price
88.72
88.68 different gap sizes, from 1 to 3 per-
88.64 cent (positive or negative). The rows
88.60 show what percentage of the gaps
88.56
were filled, and the cells show how
88.52
88.48 often they were filled (at some point
88.44 during the trading session).
Reversal 88.40 The table shows 85 percent of the
88.36
Gap up gaps between zero and 1 percent in
88.32
88.28 size (positive or negative) closed at
88.24 least halfway, and 78 percent of the
88.20 gaps closed between 90 and 100 per-
88.16
cent.
88.12
Prior day close 88.08 Although slightly less reliable,
88.04 gaps between 1 and 2 percent (posi-
88.01 tive or negative) showed a similar
1/22 15:40 15:45 15:50 15:55 1/23 9:35 9:40 9:45 9:50 9:55 10:00 10:05 10:10
Source: Great-Trade by Protrader
tendency to be partially retraced or

2 www.activetradermag.com • May 2003 • ACTIVE TRADER


TABLE 1 MORNING GAP ANALYSIS
filled. These gaps retraced by at least direction of the
half 78 percent of the time and retraced opening price for The columns show morning gaps of different sizes.
between 90 and 100 percent 62 percent of the first one to 10 The rows indicate how much of the gaps were filled.
the mornings studied. Gaps in the 2- to minutes. After
3-percent range were somewhat less this initial rally Gap size
likely to be filled. (or sell-off), the % of gap closed +/-1% +/-1 to +/-2% +/-2 to +/-3% Overall
Only 14 percent of the gaps (in the market turned 0-9 12 8 19 14
“Overall” column) closed between zero and began to 10-19 0 2 5 2
and 9 percent, which includes those close the morn- 20-29 1 6 5 2
mornings when price immediately ing gap. This 30-39 1 4 6 2
moved in the opposite direction of the reversal, on aver- 40-49 1 2 5 1
gap closure, creating what is known as a age, began six 50-59 2 5 2 1
“gap and run.” minutes after the
60-69 1 7 4 2
The second part of the analysis open, at 9:36 a.m.
70-79 2 1 4 2
explored how quickly gaps reversed. ET. The typical
80-89 2 3 2 2
The gaps typically closed half way (50 reversal was
percent) by 9:55 a.m. Of the gaps that maximized at 90-100 78 62 48 72
closed completely, 67 percent of them 9:53 a.m. ET. 50% 85 78 60 79
did so in the first 30 minutes of the trad- An approxi-
ing session, and 86 percent closed by the mately four-
end of the first hour of trading (10:30 minute countertrend move (or “jig,” futures quotes are also available through
a.m. ET). The likelihood of additional which often fakes out traders into cover- the Chicago Mercantile Exchange Web
closure declined substantially after the ing positions early) typically occurred site, www.cme.com.) Whether these con-
first hour of trading. Gaps that were still around 9:42 a.m. and lasted until approx- tracts are trading up or down in the early
open after 60 minutes closed only 4.5 imately 9:47 a.m. morning can give you an indication of
percent of the time. Also, the success rate the possible direction of the stock market
diminished on days when economic Before the bell: open.
news was released 30 minutes after the Pre-market review process Second, make note of how the futures
market open, at 10 a.m. ET. The first step in trading the MGR is antic- are affected in the pre-market by any
The third portion of the analysis iden- ipating the direction of the opening economic reports released at 8:30 a.m.
tified important time markers during the move. Usually two hours before the mar- ET. This will indicate whether the
gap-reversal period. Figure 2 (below) ket opens a reliable gap can be identified futures are strengthening or weakening
shows the typical time markers for gap by checking the pre-market stock index in pre-market trading. Make a final
reversals. Just after the open, the major futures quotes on CNBC or Bloomberg check of the futures at 9:10 a.m. (20 min -
indices tended to continue to move in the TV. (Minute by minute pre-market index utes prior to the market open).

FIGURE 2A MORNING UP-GAP TIME MARKERS FIGURE 2B MORNING DOWN-GAP TIME MARKERS

The primary time “milestones” in early trading show the The time markers for the typical down gap are the same
retracement to the previous close typically maximizes as those for up gaps.
around 9:53 a.m.

Morning peak on average Trade is maximized


9:36 a.m. EST 9:53 a.m.
Morning open — up gap
Price “jig” — usually
9:42-9:47 a.m.

Trade is Prior day


maximized closing price
Prior day Price “jig” —
9:53 a.m.
closing price usually
9:42-9:47 a.m.

Morning bottom
Morning open — down gap on average
9:36 a.m. EST

ACTIVE TRADER • May 2003 • www.activetradermag.com 3


FIGURE 3 PATTERN ENTRY

One way to enter a trade is to wait for two consecutive bars that close lower than The pattern entry approach waits
they open (in the case of a downward reversal and potential short trade), with the for the market to reverse toward the
second bar also having a lower low than the first bar previous closing price before enter-
ing the trade. The trade is taken only
88.97 after two complete one-minute bars
S&P 500 index-tracking stock (SPY), one-minute in the direction of the reversal (i.e.,
88.92
88.88 bars with closes below their opens,
88.84 and the second bar with a lower low
88.80 than the previous bar, if the reversal
88.76
direction is down), as shown in
88.72
88.68 Figure 3). The advantage of this
Pattern entry: 88.64 approach is that by waiting for the
88.60 market to confirm the reversal prior
consecutive bearish
88.56 to entry, the trader avoids entering a
one-minute bars in the
88.52
direction of the reversal. losing position on days when the
88.48
88.44 market keeps running in the direc-
88.40 tion of the opening gap. The disad-
88.36 vantage is that the trader is always
88.32 late getting into the market and may
88.28
miss significant profits as a result.
88.24
88.20 The staggered entry combines the
88.16 first two approaches by breaking
88.12 the entry into two equal halves. The
88.08 first half of the trade is placed at 9:31
88.04
88.01
a.m. and the second half of the trade
1/22 15:42 15:46 15:50 15:54 15:58 16:02 16:06 16:10 16:14 16:18 16:22 16:26 1/23 9:32 9:36
is entered after two bearish one-
Source: Great-Trade by Protrader minute bars in the direction of the
reversal. This way, if the market
There are two qualifications for the open just above established support. reverses quickly, the trader has a
behavior of the futures in pre-market Both indices and stocks exhibit the partial position already in the market.
trading. First, all three index futures con- morning gap characteristics outlined However, if the market runs in the direc-
tracts (S&P, Nasdaq 100 and Dow) must here. Index-tracking stocks such as tion of the open, only half the trade is
trade consistently in the same direction QQQ, DIA, or SPY are good vehicles for exposed.
during the pre-market. For example, if trading the MGR strategy because, not
the Dow futures are down 35 points at 8 being subject to the up tick rule, they are Stop placement
a.m. and rally to trade up 20 points by 9 easier to sell short than individual equi- Every trader’s primary focus should be
a.m., they have changed from implying a ties. For these reasons, it is recommend- controlling risk and losses. Most traders
down opening to implying an up open- ed that you concentrate on the three are quick to take a small profit when the
ing. This kind of behavior should not be major index-tracking stocks when trad- market is willing to give a larger profit,
traded. Similarly, if one contract is up ing the MGR strategy. while at the same time they expose them-
and the other is down (e.g., the Nasdaq is selves to too much initial risk and are
up 5 and the Dow Jones is down 15), it is Trade entry slow to take losses. The following guide-
not a good day to use the MGR strategy. The average reversal start time is 9:36 lines are designed to let the market con-
Second, because a very narrow gap a.m., which means the trade-entry win- trol your profit while you control your
reduces profit potential, gaps in the dow is generally from 9:30 to 9:42 a.m. If risk.
futures contracts must be in excess of 5 a position has not been initiated by 9:42 The strategy uses three kinds of stop-
points for the S&P 500 futures, 10 points a.m., no trade is taken for the day. Three loss orders, the sizes of which are
for the Nasdaq 100 futures and 20 points entry techniques can be used with the intended for SPY, DIA and QQQ. The
for the Dow Jones futures. MGR strategy: time entry, pattern entry first type is the “high-low” stop. The
and staggered entry. primary risk in an MGR trade is the
Other factors A time entry consists of “playing the market will continue to run in the direc-
In addition to watching pre-market trad- averages” by entering a trade at 9:36 a.m., tion of the gap. Therefore, if the index-
ing activity, evaluate the support and regardless of what the market is doing at tracking stock trades 15 cents above the
resistance in the market you intend to the time. This approach has the advantage highest high of the morning (for up
trade. Be aware of the projected opening of being easy to execute, but it also runs gaps) or below the lowest low of the
price of the security relative to any sig- the risk of putting you immediately on the morning (for down gaps) after 9:45 a.m.,
nificant support or resistance levels. losing side of the market. Despite these the position should be closed. This is the
Often a market that is gapping up will disadvantages, a trader without a real- worst-case scenario and will yield the
open just under an established resistance time trading setup system may prefer this strategy’s largest losses.
level; a market gapping lower might method because of its simplicity. The second stop-loss is a trailing stop

4 www.activetradermag.com • May 2003 • ACTIVE TRADER


that requires evaluating where the FIGURE 4 SHORT-TRADE EXAMPLE
trade is relative to the best price it
has experienced up to that point. In this case, the entire morning gap was filled in the first 20 minutes of trading,
First, once a 25-cent profit has been at which point half the trade was liquidated and a 25-cent trailing stop was used to
reached, move the stop to protect the remainder.
breakeven. When a 35-cent profit 84.274
is in place, trail the stop-loss 25 Dow Jones Industrial Average index-tracking Initial stop-loss is placed at the
stock (DIA), one-minute morning high plus 15 cents 84.20
cents above the highest high (for a 84.16
short trade) or below the lowest 84.12
84.08
low (for a long trade) reached dur- Pattern entry 84.04
(Two consecutive one-minute 84.00
ing the trade. 83.96
For example, if the position is bars in the direction 83.92
of the reversal) Exit remainder of 83.88
up 35 cents and moves back to 83.84
position at 9:55 a.m ET 83.80
being up only 10 cents, exit the (83.47) 83.76
trade; if the position is up 50 cents Entry: 83.72
Price — 83.74 83.68
and moves back to being up only 83.64
Time — 9:37 a.m. ET 83.60
25 cents, exit the trade. This 83.56
approach continually moves the 83.52
83.48
stop in the direction of the trade. 83.44
83.40
The third stop is the “time 83.36
83.32
stop.” Because this strategy is 83.28
most successful in the first 30 min- 83.24
83.20
utes of trading (and because eco- 83.16
nomic announcements often occur Exit 50 percent of the position (at 83.24) when 83.12
83.08
the entire morning gap is closed. 83.04
at 10 a.m. ET), the time stop liqui-
83.01
dates any position that is still open 1/22 15:30 15:35 15:40 15:45 15:50 15:55 1/23 9:35 9:40 9:45 9:50 9:55 10:00
at 9:55 a.m.. This allows the trader Source: Great-Trade by Protrader
to take advantage of the most ben-
eficial time period without exposing the However, when the gap closes entire- technique could have been used.)
trade to the volatility of adverse reac- ly before 9:55 a.m., half the position The market continued to move lower,
tions to news. should be closed. (The prior day’s close first reaching the 25-cent profit level at
In actual trading, the majority of los- is a natural resistance/support level; if it approximately 9:41 a.m., at which point
ing trades are stopped out with a loss of is penetrated, the possibility of a turn- the stop is moved to breakeven. Next,
50 cents or less. In tests, a 50-cent around off that level emerges.) The sec- DIA reaches the prior day’s closing price
absolute stop in the SPY and DIA was ond half of the position should be kept around 9:48 a.m. When this target was
rarely hit. The lower price of the QQQ open in case the market continues to reached, 50 percent of the position was
made them even less susceptible to being move profitably. closed for a 50-cent profit.
hit; the typical maximum loss in the Finally, the “jig” mentioned in the sta- From this point onward, the balance of
QQQ is closer to 30 cents than 50 cents. tistics section occurs quite frequently the position would be exited with the 25-
between 9:42 and 9:47 a.m. ET. Because cent trailing stop or at 9:55 a.m., whichev-
Position sizing this countertrend move can fool a trader er comes first. In this case, the time stop
Correct position sizing will enable you into closing a position too quickly, try to was reached, closing the second half of
to focus on the strategy without being avoid closing a position during this time the trade at $83.47 for a 27-cent profit. The
distracted by unnecessary anxiety. A frame. Stick to your original stop-loss trade’s total profit was just over 38 cents,
conservative money management levels. taking into account the two exits.
benchmark is to risk no more than 2 per-
cent of account equity on a trade. This Trade example Statistical foundation
means a trading account of $25,000 Figure 4 shows the Dow Jones Industrial and tight risk control
could afford to risk $500 per trade Average tracking stock (DIA) opening The MGR strategy is based on the favor-
($25,000 x .02 = $500). Because this strat- higher (on Jan. 23, 2003) than the preced- able statistical performance of early
egy typically stops out a losing trade ing close, setting up a potential short morning reversals back to the previous
within 50 cents of the entry, it’s possible sale. day’s closing price. It combines a high
to trade up to 1,000 ($0.50 x 1,000 = $500) Using the simplest entry approach, a winning percentage with conservative
shares. short trade was entered at 9:37 a.m. ET at risk management.
$83.74 (the market was already starting The strategy’s simplicity makes it
Caveats to retrace toward the previous closing easy to monitor and “paper-trade” in
The stop-loss rules are structured to let price of $83.24). The initial stop-loss was real-time, which lays the groundwork
the market determine how large the placed at $84.07, which corresponds to for actual trading. Ý
profit should become when the trade the morning high plus 15 cents. (The
runs in the desired direction. chart also shows where the pattern entry For information on the authors see p. 12.

ACTIVE TRADER • May 2003 • www.activetradermag.com 5


TRADING Strategies

Trading the overnight


With increasingly reactionary markets
GAP
comes the higher risk of opening gaps.
Learn how to spot the early warning signs
and how to take advantage of them.

When buying interest exceeds selling ket opens), market makers have an
interest, the gap will obviously be to the incentive to open a stock at extreme lev-
upside and vice versa. However, what is els directly correlated to the imbalance.
BY DAVID S. NASSAR not known is the price level at which the This simply means that if an imbalance
stock will open, and the precise risks is on the demand side, and a given stock
associated with being long or short in a is going to open strong, market makers
particular situation. will open it as high as they can, taking
Until recently, these price levels were the opposite side of the trade on open
often determined exclusively by large buy orders.

I
“off-floor” markets, such as Instinet, an Because most members of the public
institutional trading network that was trade only the long side of the market,
the first outside-market-hours trading many unsuspecting amateurs buy into
n today’s markets, many stocks medium. Today, with the advent of gap-up openings at what often will be
can have large supply-demand many other Electronic Communications the high price of the day. As a result, it is
imbalances at the opening bell. Networks (ECNs), there are many more worthwhile to explore the possibility of
Often, these imbalances result in retail traders active in pre- and post- trading situations when a gap will not
what are known as gaps, when the open- market trading. However, even though hold (reverses), rather than those
ing price is higher or lower than the pre- the public has access to the pre-market, instances when the stock follows
ceding close. the levels that trade pre-market are still through with a move in the same direc-
News, in various forms, is generally mostly influenced by market makers tion. Whether the stock reverses and
the catalyst for gap openings. The most who bid or offer stock at price levels closes the gap or follows through in the
common type is macroeconomic news away from the previous day’s close same direction, this move is perhaps the
such as FOMC meetings, the release of when imbalances appear in their auto- strongest indication of what the trend
economic indicators such as unemploy- mated systems. will be for the stock shortly after the gap
ment or the Consumer Price Index (CPI), Because many of these imbalanced opening. In the example of bullish gaps,
or stock-specific news such as earnings orders are “market on open orders” stocks that fail to meet new highs from
surprises or analyst upgrades or down- (meaning they are to be executed at the the opening levels will have a greater
grades. “best” available price as soon as the mar- likelihood to retrace and lose much of

The first clue that a stock is ripe for a gap opening


is an increase in volume over its normal daily average.
6 www.activetradermag.com • March 2001 • ACTIVE TRADER
FIGURE 1 CHARGING LOWER
Starting in September 2000, the uptrend in Intel (top chart) came to a halt,
punctuated by a series of downside gaps. Typically viewed as a blue-chip stock
free of extreme volatility, Intel became much more volatile after the first
down gap; it became a "charged" stock that propelled the entire semiconductor
sector lower (bottom chart).

the opening gap. Intel (INTC), daily


75
Conversely, stocks that remain
strong and trade to new highs after the 70
opening gap will have a greater likeli- 65
hood of following through and trend-
ing higher. While this shouldn’t be 60
interpreted too rigidly (there are other 55
indicators to monitor, such as index
strength and sector strength, etc.), it is 50
the strongest single indication of how a 45
stock will trade following a gap open-
ing. 401⁄32
39
Regardless of whether gaps are to 35
the upside or downside, it is important
to study the impact they have on Volume 300,000,000
stocks. The following components and 200,000,000
considerations are most important
100,000,000
when trading gaps: 74,009,300
0
28 5 11 18 25 2 9 16 23 30 6 13
• Charged stocks/sectors; Sept. Oct. Nov.
• Volume and volatility;
• Chaos and over-activity; 1200.00
PHLX Semiconductor Sector Index (SOX), daily
• High risk (elasticity). 1150.00
1100.00
Let’s look at each of these factors.
1050.00
Where the action is: 1000.00
Charged stocks and sectors 950.00
Once a sector is in the public eye, think 900.00
of the component stocks as being 850.00
pumped up or “charged.” When this 800.00
occurs, the volume in the stock will 750.00
increase, and there will be a tremen- 700.00
dous swing in the trading range from 651.22
one session to the next, either to the 600.00
upside or downside. Before the open- 21 28 5 11 18 25 2 9 16 23 30 6 13
ing bell, in the absence of actual trade Sept. Oct. Nov.
activity, market makers will predict Source: QCharts by Quote.com
price pattern changes — either slightly
before an event or immediately after one immediately after. As you can see from increase will occur before the news is
— and bid the stock higher or lower the chart, Intel did not hold its levels known. This is an indication that news is
based on their predictions. after the first gap and followed through leaking in the market and explains the
If a major stock within a sector experi- by trending lower, as did the SOX index. cliché “stocks tell their own story” ahead
ences negative or positive news, it can of news. Remember, the biggest trading
charge an entire sector. Figure 1 shows Early warning signs: houses often have strong indications of
Intel (INTC) gapping down after nega- Volume and volatility sector and stock strength/weakness
tive news on inventories. The entire The first clue that a stock is ripe for a gap before the media. Therefore, when
Philadelphia semi-conductor index opening is an increase in volume over its increases in daily volume accompanied
(SOX) became charged and volatile normal daily average. Often, the volume by directional bias are seen in the

ACTIVE TRADER • March 2001 • www.activetradermag.com 7


absence of news, a gap is generally not heavy buying and selling, which result get whipsawed out of trades, taking
far behind. in small price movements until one side many losses. Certainly, you also need a
The best way to track volume is by ultimately gains control. Once a clear clear picture of what the broader price
knowing the average daily volume for imbalance is revealed, whether bullish action looks like before even thinking
the stock or sector in question, in combi- or bearish, the volume tends to dry up as about adding volatile, big-range stocks
nation with its key trading levels (sup- market participants start to lean over to to your watchlist. It is also important to
port or resistance). Watching the time one side of the supply/demand scale. dramatically lower your size in these
and sales ticker is an excellent way to For example, if the bulls gain control at a trades, because the range of the price

Stocks tend to overreact and move to extreme price levels,


which sets up the possibility
of a correction in the next trading session.
monitor changing volume for short-term key support level, buyers will exceed swings offsets the trade size needed to
intraday trades. If the ticker is moving sellers and the stock will trade higher on profit.
fast, you are seeing an increase in vol- less volume as the buyers lift thin offers Seeing the broader view of the market
ume — it’s that simple. at each price level. is like a hurricane: When you’re in it, it is
When this occurs, you are generally The lesson here is that volume indi- chaos, but if you can get far enough
looking at a “vertical spread” (VS) situa- cates where the battles are fought away, you can see the larger pattern and
tion. A high VS means the price pattern between bulls and bears, but once a direction. When you trade chaotic
is changing rapidly, up or down, and dominant bias is revealed, the stock will stocks, you must trade them accordingly
you will need to “lead” the market (i.e., move the most on lighter volume. Gaps or avoid them altogether.
place a limit order that is the best bid or are the ultimate example of this: no vol- To determine if a chaotic market cli-
offer) to buy or sell as the range widens. ume exists, but extreme price change mate in general, and the overnight-gap
A slower-moving issue that has a tight does. Once this gapping action begins, trade in particular, is for you, ask your-
“horizontal spread” (HS), where the chaos is not far behind. self the following questions:
spread between the bid and ask is tight, 1. Do I have the account size required
say 1⁄16, will not require leading. If the Chaos and high risk: to take the necessary risk?
stock has a tight HS, you can easily “lift Are gaps worth it for you? 2. Do I have the temperament and
offers” or “hit bids” — or even buy bids Chaos reaches its peak when stocks have the required level of risk tolerance?
and sell offers –— during tight price no real support or resistance levels in 3. Am I “in the money” and willing
range situations. sight. For example, if a stock is not well to take on additional risk for
To spot volume changes that may lead supported until it trades 20 points lower, additional reward?
to gaps, it is important to take a broader volatility will be extreme. 4. Do I have clarity and confidence
view of both the volume and the market These such conditions represent a enough to see the gap coming?
itself. Notice the dramatic volume day-trading environment only. This is 5. Did I day trade this stock the entire
increase in Intel over the course of sever- not a time to take overnight positions. day prior to the anticipated gap?
al days, in Figure 1. However, the vol- Remember, volatility can also be defined If you answered “no” to any of these
ume interpretation changes within each as chaos and, therefore, you can throw questions, don’t even think about taking
move and the stock will move the most your technical tools and indicators out the trade. If you answered “yes” to all of
on the least volume once it is in motion. the window. If you want to day trade in the questions, then you have the criteria
For example, when stocks are growing this climate, you must take a micro view to attempt it. Here’s how to do it.
weaker, panic and fear is heightened and of the stock, taking small incremental
fewer buyers are stepping up. Therefore, profits and losses vs. trying to trade the Taking the trade
as buyers disappear from the market, overall trend. Let’s begin with the fact that, because of
stocks fall harder on light volume and Also important is that gaps often volatile price pattern movements during
with a wider range before new support reveal the beginning of new trends. the day, stocks will tend to overreact or
levels are found. Once the stock estab- However, if you’re a longer-term posi- overtrade, moving to extreme price lev-
lishes support levels, the volume builds tion trader in these situations, you must els that are extreme. This sets up a possi-
dramatically as buyers remain strong, have a much higher risk tolerance ble correction for the next trading ses-
while sellers are still in the market. It is because these price fluctuations are part sion, when market makers will often gap
at these levels that the true battle of the equation. Otherwise, you will con- the stock price to levels that are advanta-
between bulls and bears takes place. stantly employ “discipline” at the wrong geous for them.
These campaigns are evidenced by time (placing stops too close, etc.) and The first gap that sets the stock in

8 www.activetradermag.com • March 2001 • ACTIVE TRADER


FIGURE 2 EARNINGS DISAPPOINTMENT

Leading up to the earnings release on Oct. 27, shares of American Power Conversion (APCC) traded from 18 to 22 in
five days. The earnings didn’t live up to expectations and the stock gapped nearly seven points lower the following day.

American Power Conversion (APCC), 10-minute


22

21

20

19

18

17

16

15

14

13 1⁄16

Volume
1,000,000

500,000

255,300

0
11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11
10/20 Friday 10/23 Monday 10/24 Tuesday 10/25 Wednesday 10/26 Thursday 10/27 Friday 10/30 Monday

Source: QCharts by Quote.com

motion because of unforeseeable news is ments. This is because most positive earn- expectations.
generally not predictable. However, the ings expectations are built into the stock Short squeezes and profit taking.
gaps that may follow can occur for some price in the days prior to the report. For Short squeezes and profit taking are the
of the following reasons: this reason, stocks have a greater propen- most common reasons stocks will tend to
• Additional news, such as earnings sity to fall when companies merely meet build above-average volume into the
releases. expectations. close and cause what is called a “hook”
• Short squeezes and profit taking When expectations are missed, the close.
(“hook” closes). downside bias is dramatic. Therefore, In a short squeeze, a stock is in a
• S&P 500 futures volatility. you should rarely take an overnight downtrend and market makers suspect
These different factors can provide position in a company that is reporting there may be many short sellers in the
various signals that offer opportunities earnings after the close. If you do, your market. The squeeze and the hook occur
for gap trades. natural bias should be to trade the short when the professionals begin to buy the
Earnings. Earnings are perhaps the side — especially in this market environ- stock rapidly into the close, causing price
most significant factor regarding gap ment, where good earnings are often no to rise swiftly and forcing the short sell-
trades, because they have such a sub- match for inflationary pressure, rising ers to cover in a panic. Profit taking gen-
stantial impact on both stocks and sec- interest rates and oil prices. erally occurs when a stock is in a rising
tors. Because so many stocks have an trend but shows a weak close accompa-
The market is far more unforgiving of upside bias in the days prior to an earn- nied by high volume. At this point,
missed earnings than it is rewarding to ings report, it is best to sell into the news traders with long positions begin to sell
earnings that meet estimates. Many com- if you’re long the stock, and wait for the the stock to take a profit. Figure 3 shows
panies meet expectations and still get outcome. Figure 2 is an example of what an example of a short squeeze, while
hammered the day after their announce- companies experience when they miss Figure 4 is an example of a hook formed

ACTIVE TRADER • March 2001 • www.activetradermag.com 9


FIGURE 3 SHORT SQUEEZE

On Oct. 26, Amgen (AMGN) closed the day near its high on a sudden spurt of buying that was likely the result of a short
squeeze. A look at the intraday chart reveals the stock was in a downtrend, with the previous support level at 69 1⁄2
becoming resistance.

Amgen (AMGN), 5-minute 72

70

68

66

64

62

60
59 1⁄8
1,200,000
Volume 1,057,900
1,000,000
800,000
600,000
400,000
200,000
0
12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10
10/25 Wednesday 10/26 Thursday 10/27 Friday
Source: QCharts by Quote.com

during profit taking. hold a losing position overnight, hoping all other questions and factors can be
If you’re not in a profitable situation the stock will “come back.” That is noth- answered favorably, you could keep
from day trading the stock, you should ing but gambling. your long position overnight.
not take the overnight gap trade. It is S&P 500 futures. S&P 500 futures are The point is you must have clarity and
best to stand aside and trade the open an important consideration when taking confirmation on all levels when taking a
the following day, after the stock gaps an overnight gap trade. You should look position overnight. Still, the most signif-
open — if it does. If you had a profitable at the correlation between the futures icant piece of information comes from
day-trading session, you can take the market and the index in relation to the the stock itself and how it behaved while
overnight position if you think the risk- gap-trading plan you have in mind. If you where trading and watching it in the
reward relationship is satisfactory. the futures are moving decisively higher days prior to the anticipated gap.
Remember, when going after an going into the close, and you have other Without this information, you will not
overnight position, it must always be independent reasons for the stock in be able to make a decision whether to
with purpose and confidence. Never question to gap higher the next day, and take a gap trade or not.
Gap trading is a risky business, and
the professionals who quote stocks up or
The first gap that sets the stock down prior to the open have a vested
interest in doing so. If you were a market

in motion because of unforeseeable news maker who made your living buying and
selling stocks from the public while pro-
viding liquidity to the market, where
is generally not predictable. would you open a stock with poor news
knowing you were to receive market on

10 www.activetradermag.com • March 2001 • ACTIVE TRADER


FIGURE 4 PROFIT-TAKING
Transwitch Corp. (TXCC) was on its way to recovery from a sell-off in the fiber optic group. Along the way, profit taking
on Oct. 30 forced the price lower at the end of the day. The next morning the stock gapped higher, with the buyers
once again firmly in control.

Transwitch Corp. (TXCC), 5-minute


56 5⁄16
56

54

52

50

48

46

44

42

Volume 200,000

150,000

100,000

50,000
8,200
14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12
10/27 Friday 10/30 Monday 10/31 Tuesday
Source: QCharts by Quote.com

open orders? You would open it as low as stock to buyers at what would be a sig- By contrast, if the stock continues to fol-
possible, where you felt the stock was nificant resistance level. This is referred low-through in the direction of the gap, it’s
well supported. This is known (from the to as “selling strength.” a strong indication that the trend will con-
market maker’s perspective) as “buying This is why gaps have a greater pro- tinue.
weakness.” pensity to close immediately after the Remember, however, that while these
Conversely, with strong news, know- open: After the initial panic selling or rules are good to use as a guide, they
ing you would be selling at the open, mania buying has been gobbled up by the should not be traded with indiscretion.
where would you open the stock? The market maker or specialist, a vacuum There are many factors that impact any
higher the better, so that you could short often develops and the stock will reverse. individual gap-trading situation. Ý

The market is far more unforgiving of missed earnings


than it is rewarding to earnings that meet estimates.
You should rarely take an overnight position in a company
that is reporting earnings after the close. If you do,
your natural bias should be to trade the short side.
ACTIVE TRADER • March 2001 • www.activetradermag.com 11
FUTURES & OPTIONS
Trading Strategies

Trading the OPENING GAP


Watching pre-market volume is a good way to determine whether
to trade or fade the opening move.

BY JOHN CARTER those in “multi-item” instruments such because of the diversity of their compo-
as stock indices because a news item will nent stocks. Both indices represent collec-

O
control the entire market instead of just a tions of stocks from different industries
portion of it. Earnings announcements, that are more likely to react independent-
corporate scandals and other company- ly to news events. In the technology-
pening price gaps — the specific events can create gaps in a com- heavy Nasdaq, opening price gaps can
distance between the reg- ponent stock’s chart that never get filled. take longer to fill because the majority of
ular-session opening price Because of the unpredictable nature of the stocks will react similarly to news.
and the previous day’s various events that can impact the price The key to trading opening gaps is
closing price — are stomach-churning of an individual stock, they make poor being able to predict the likelihood a
events when the market makes a big candidates for the opening-gap trade. particular gap will be filled. Dissecting
move against you, but they represent In contrast, stock index futures such as the market conditions that produce a
low-risk trade opportunities if you know the E-mini S&P (ES) or the mini-sized gap is as important as analyzing a gap
which gaps are likely to be followed by Dow (YM) are better candidates for itself. For example, an opening gap fol-
predictable patterns. opening-gap plays because they consist lowing high pre-market cash trading
In terms of the price behavior that fol- of multiple components that respond dif- volume can take weeks to get filled
lows opening gaps, not all markets are ferently to news. For example, although a because high volume increases the odds
created equal. Gaps in individual stocks stock index futures contract may gap up the market will continue to move in the
and commodities do not act the same as on a news item, there will be individual direction of the gap.
stocks within the index that will either Some of the biggest gaps are caused
TABLE 1 FILLING THE OPENING ignore the news or sell off. This weighs by major news events, such as the out-
GAP: RAW DATA the index down and creates a trade break of a war, but gaps caused by minor
opportunity as the market fills the gap. news items are much more common.
Between Jan. 15, 2002, through Generally, such gaps are smaller, fill
February 2004 (528 occurrences), The best markets for gap plays quickly (see Table 1) and can be “faded”
an average of 76 percent of all The S&P 500 and the Dow are the best (the act of trading against the direction
opening gaps closed at some point markets to trade the opening gap of the gap) more effectively. Let’s look at
during the same day. This is the
breakdown by day of week. Adding
the pre-market volume filter TABLE 2 TRADE MANAGEMENT GUIDELINES
increased the percentages. The higher the volume, the greater the likelihood the market will continue
in the direction of the opening gap. As a result, no trade is taken when vol -
Percentage of ume is above 70,000.
Day gaps filled
Pre-market volume
Monday 65% in key stocks Position size Trade target
Tuesday 77% Less than 30,000 Full size Exit entire position at gap fill
Wednesday 79% Between 2/3 size Exit half at 50 percent of gap
Thursday 82% 30,000 and 70,000 fill, half at gap fill

Friday 78% Above 70,000 No “fade” trade No “fade” trade


Source: Tradethemarkets.com Source: Tradethemarkets.com

12 www.activetradermag.com • December 2004 • ACTIVE TRADER


If the market is poised to move, there
the specific criteria for identifying those
gaps with the best chances of reversing. will be significant pre-market volume
The pre-market volume indicator in certain stocks.
The most important indicator for deter-
mining which opening gaps can be
faded is the pre-market volume in a spe- mini Dow futures. You can use any time the Dow gapped up 47 points as a result
cific set of stocks. interval — a one-minute, five-minute or of a positive earnings report from Intel
Check the pre-market volume at 9:20 15-minute chart, etc. — as long as you (INTC). On this day, pre-market volume
a.m. ET (10 minutes before the regular can view the opening. This means the was below 30,000.
cash session opens) in the following chart must be set up to reflect the open- As a result, the appropriate trade is to
stocks: KLA-Tencor Corporation (KLAC), ing and closing of the regular trading immediately short the gap on the open
Maxim Integrated Products, Inc. (MXIM), session, 9:30 a.m. to 4 p.m. ET (4:15 p.m. using a full position size, as indicated in
Novellus Systems, Inc. (NVLS) and for stock index futures prices). Many Table 2. To keep things simple, we’ll use
Applied Materials, Inc. (AMAT). These traders are used to watching a separate nine contracts as a full position, which
representative stocks were selected chart of the continuous 24-hour futures makes a two-thirds position six contracts
through a trial-and-error process. session, but of course, opening gaps and a one-third position three contracts.
If the market is really set up to move,
there will be significant volume in the FIGURE 1 THE OPENING GAP
cash market in pre-market trading. If the
market is setting up for a “head fake” (a This 47-point-plus opening gap in the mini Dow futures was filled in the first
move in one direction that is quickly hour of trading for a $235 per-contract profit.
reversed), pre-market volume will be
low, which reflects a lack of conviction in 9,830
Mini Dow futures (YM), five minute
the move. This is the preferred setting
9,820
for an opening-gap trade.
If the pre-market stocks have each Gap is filled for a 47-point
9,810
traded less than 30,000 shares at this gain, or $235 per contract
time, analysis of the prior 500 trading (47 points x $5 per point). 9,800
days shows the opening gap, up or
down, had an 80-percent chance of fill- 9,790
ing the same day. However, if the vol-
9,780
ume for each stock is between 30,000
and 70,000, the gap only has about a 60- 9,770
percent chance of filling that day, while
the midpoint of the gap has an 85-per- 9,760
cent chance of being hit.
Finally, if the pre-market volume for 9,750
each stock is above 70,000, the chances of
9,740
the gap filling that day drop to 30 per-
cent. In these cases, you should ignore 9,730
the news and follow the direction of the
gap. Table 2 provides guidelines for 9,720
using volume information to manage
trades. As the volume increases, the 9,710
position size shrinks and the profit-tak-
10/15/03 9,700
ing becomes more conservative.
If one stock has volume above 70,000 11:00 12:00 13:00 14:00 15:00 9:00 10:00
but the others are below the threshold,
Source: eSignal
check to see if the news pertains to this
company alone. If it does, ignore it. If the
news is not specific to the company, won’t show up. We will use a $100,000 account, which
trade the more conservative position. Figure 1 shows the first day in a set of means we are trading one contract for
back-to-back earnings announcements each $11,100 in the account for a full posi-
The strategy that caused opposite reactions in the tion. Although you can trade a mini Dow
Figure 1 is a five-minute chart of the market. On the morning of Oct. 15, 2003, or E-mini S&P contract with only a few

ACTIVE TRADER • December 2004 • www.activetradermag.com 13


FUTURES & OPTIONS
Trading Strategies continued

FIGURE 2 THE DAY AFTER thousand dollars, this trading plan con-
trols risk by limiting exposure relative
One day after the trade setup shown in Figure 1, the mini Dow contract to the amount of available capital.
opened lower, setting up a long trade. Use a 1:1.5 reward/risk ratio (risking
9,800 1.5 points to make 1 point) for gap
Mini Dow futures (YM), five minute trades that are less than 40 mini Dow
points or 4 E-mini S&P points. For gaps
9,790 larger than these, use a 1:1 reward/risk
Gap filled for a 61-point ratio. In the case of Figure 1, we would
gain, or $305 per contract. 9,780 risk 47 points to make 47 points. If the
gap had been 30 points, we would risk
9,770 45 points.
Some traders might question an
approach that risks more than the
9,760
potential profit. Most beginning traders
are taught to use a 3:1 reward/risk
9,750 ratio, risking 1 point to gain 3. They
inevitably wonder why they are repeat-
9,740 edly stopped out just before the market
turns. In general, wider stops produce
more winning trades; the key is to trade
9,730
only those setups with a better than 80-
percent chance of winning.
9,720 The market sold off immediately
after the bell, filling the opening gap
9,710 within an hour. Ironically, the next day
IBM came out with a disappointing
earnings report, knocking the market
10/16/03 9,700
down on the open. Figure 2 shows the
15:00 9:00 10:00 11:00 12:00 13:00 14:00 resulting buy setup had just a small
Source: eSignal open loss at one point, although many
traders might have been stopped out
FIGURE 3 EMOTIONS TRIGGER GAP on the pullback around 11 a.m. ET.
However, keep in mind the strategy
The E-mini S&P futures made a downside opening gap on Aug. 2, 2004, on terrorist is to maintain a reward/risk ratio of
threats. The market spent most of the day filling the gap. 1:1, not to tighten your stop when
the market moves in your favor. If
E-mini S&P 500 continuous contract (ES), five minute 1,106 the stop had been hit, the loss would
have been approximately $305 per
1,105 contract ($2,745 for the nine-contract
Close on 7/30/04:
1,103.75 full position), not including slippage
1,104 and commissions. This loss is rea-
sonable because of the 80-percent
1,103 success rate of the setup.
Using a tighter initial stop or trail-
1,102
ing stop would have turned this
position into a losing trade or, at
1,101
best, a breakeven trade. Using the
1,100
risk parameters designed for this
trade setup allowed the position to
1,099 remain open until the gap was filled
for a gain of 61 points. As a rule,
1,098 using a trailing stop will negatively
affect the gap trade’s win/loss ratio.
1,097 When the trade is executed, the
Open on 8/2/04: best thing a trader can do is to walk
1,097.00 1,096 away and let the orders do their
14:45 15:0515:25 15:45 8/2 10:00 10:2010:4011:00 11:20 11:4012:00 12:20 12:40 13:00 13:2013:40
work. This is the difference between
professionals and amateurs:
Source: TradeStation Professionals won’t second-guess a

14 www.activetradermag.com • December 2004 • ACTIVE TRADER


FIGURE 4 MULTIPLE GAPS
trading methodology, while ama-
teurs are constantly adjusting. The first opening gap on this chart — which remained unfilled for the next six days —
set up a short trade that was stopped out for a loss. Subsequent opening gap trades
Ignore the reasons for the gap were more successful.
The size or cause of a gap has little 9,500
Mini Dow September futures (YMU04), 15 minute
impact on whether or not it will be
filled. Figure 3 shows an example 9,480
Gap of +62 points
of emotions triggering an opening Gap of -52 points fills in 6 bars
price gap when, on Aug. 2, the fills in 9 bars 9,460
market gapped down on the open
Short break of bear 9,440
because the U.S. government Gap of +13 points
flag. Target is gap
issued a terror warning the previ- fills in 1 bar
from 8/18 9,420
ous day. There were rumors of a
plan to blow up a large financial
9,400
institution.
However, after a choppy first 9,380
half of the day, the market firmed,
shorts got nervous and started cov- 9,360
ering, and the gap was filled by Gap of +44 points fills in 9 bars
1:30 p.m. ET for a 6.75-point S&P E- 9,340
mini profit ($337.50 per contract).
9,320
Relax and trade
Figure 4 shows a 15-minute chart of 9,300
the September mini Dow futures Gap on 8/18 of +44 points
fills on 8/25 9,280
(YMU04) with an opening gap on
Aug. 18 that did not get filled for
six trading days. (Other opening 8/18 13:15 8/19 11:45 14:15 8/20 12:45 8/21 13:45 8/22 12:15 8/25 13:15 8/26
gaps occurred before price eventu- Source: TradeStation
ally filled the first gap.) On this day,
the mini Dow gapped up a modest profit ($2,295). All these gaps followed each type of trade setup.
44 points prior to the release of some light pre-market volume, so they were Gaps are the one moment of the trad-
economic numbers. The pre-market vol- executed with full positions. ing day where everyone has to show
ume was modest, between 30,000 and On Aug. 22, 2003, Intel announced their poker hand, and this creates a big
70,000 shares for the key stocks, so the “cautious upside earnings revisions.” advantage for short-term traders.
appropriate step was to short a two- The market exploded to the upside and Understanding the dynamics behind
thirds-size position on the open. gapped right above key resistance. The opening gaps is paramount to trading
The market rallied, sold off a little just trade was to short the 62-point gap with them successfully.Ý
prior to the economic numbers, and then a full-size position. Six bars later, the tar-
shot higher once the numbers were get was hit for a 62-point profit, or $310 For information on the author see p. 10.
released. Using the 1:1 reward/risk ratio per contract ($2,790).
resulted in a 44-point stop. The market During the afternoon session, the mar-
never retraced to the gap’s midpoint ket traced out a bear flag pattern. With Related Active Trader
level (where half the position could be the opening gap under the market still articles
covered), and instead rallied right unfilled, the trade was to place a sell stop
“Trading the overnight gap” by David
through the stop, producing a loss of at 9,392 to let the trend of the market ini-
Nassar, March 2001, p. 66
$220 per contract. For a two-thirds posi- tiate the trade based on a breakdown of
tion (six contracts) the loss was $1,320. the flag. The entry stop was filled and the “Morning reversal strategy” by Bryan
This move left an open gap below the risk point for the trade was above intra- C. Babcook and Arthur Agnelli,
market. The next day the market opened day resistance at 9,455. The target was the May 2003, p. 36
modestly lower, triggering a long trade Aug. 18 gap at 9,304. The market spent “Technical Tool Insight: Gaps,” April
that resulted in a quick $65-per-contract the rest of the day trending lower, filling 2003, p. 82
profit ($585 total). The following day the the gap and resulting in an 88-point gain,
market opened 52 points lower and or $440 per contract ($3,960). “Technical Tool Insight: Islands,”
filled the gap a few hours later for a August 2002, p. 82
$260-per-contract profit ($2,340). The A brief window of opportunity You can purchase past articles online
next day, the market gapped up 44 The market’s nature is to prevent as at www.activetradermag.com/
points, triggering a short trade that came many people as possible from consis- purchase_articles.htm and download
close to the stop-loss point, but eventual- tently making money, which is why it is them to your computer.
ly filled the gap for a $255-per-contract crucial for a trader to follow rules for

ACTIVE TRADER • December 2004 • www.activetradermag.com 15


FIGURE 1 EQUITY CURVE
The frequency of down gaps increased after the broad market topped out in early
2000. The system exposure (light green area) increased substantially after this
point. Note that many of these gaps are still open.

Gap closer 130,000

120,000

Markets: Any. 110,000

100,000
System concept: Most traders are familiar
with the technical analysis axiom, “All gaps 90,000

are eventually closed.” A gap occurs when a 80,000


price bar’s high is lower than the previous low
70,000
or its low is higher than the previous high. A
significant gap creates a void in which no 60,000
trades occur, as shown in Figure 1. An “open- 50,000
ing gap” occurs when price opens above the
40,000
previous high or below the previous low; such
gaps can be filled the same bar, in which case 3 0,000
no visible bar-to-bar gap (such as the one in 20,000
Figure 1) will appear on the chart.
10,000
The idea that gaps are eventually closed
stems from the absence of trades within the 0
range of the gap. Because there are no traders 3/3/93 1/7/94 1/3/95 1/2/96 1/2/97 1/4/99 1/3/00 1/2/01 1/2/02 1/2/03
who are holding positions within the gap zone Equity Cash Linear reg
(some may have entered positions earlier in
the chart’s history), there is an absence of the
upside resistance that is typically caused by traders seeking to resistance, price often moves sharply to close the gap when it
exit at breakeven or a profit-target level. Because of this lack of first recovers and penetrates the gap zone. This type of price
movement can also lead to the “island
FIGURE 2 SAMPLE TRADES reversal” pattern, which occurs when a
gap in one direction is followed by (after
The system went long when Apple Computer gapped down more than 13 percent on
one or more intervening bars) a gap in the
June 19, 2002. Price started moving in the direction of closing the gap, but another
down gap occurred on July 17, 2002, causing a new long position to be established. opposite direction.
This test is designed to see if the axiom
Apple Computer (AAPL), daily regarding closing gaps holds water. The
10 gaps, seven closed (70%) 25.00 system tested here goes long the day after
24.00 a large gap down and holds the position
until price reaches the low of the bar
23.00 immediately before the gap — i.e., when
22.00
the gap is closed.
This “system” is for experimental pur-
21.00 poses only. The goal is to test the effective-
ness of trading gaps in the simplest way
20.00
possible; no protective stops are included.
19.00 Because of this, positions can be held
indefinitely and result in substantial draw-
18.00
downs when gaps are never closed. If you
17.00 wanted to actually trade a gap-based sys-
tem, you would most likely use a protec-
16.00
Buy
tive stop to protect against these losses.
15.00
Rules:
14.00 1. Enter long on the open the day after a
Volume Buy
down gap greater than the 20-bar aver-
20M
age true range (ATR) is completed.
2. Place a limit order to sell the position at
the low price of the bar that immediate-
July 2002 August 2002 September 2002
ly preceded the gap.
Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)
3. The system will maintain multiple

16 www.activetradermag.com • May 2003 • ACTIVE TRADER


FIGURE 3 DRAWDOWN CURVE
As more gaps were opened and more long positions established,
open long positions (see Figure 2). a large drawdown began in 2000.
4. Hold the position indefinitely until the gap is 0%
closed and the limit sell is triggered. -2%
-4%
Money management: Risk 9 percent of account -6%
-8%
equity per trade. This level was chosen because
-10%
it was the largest position size that allowed all
-12%
gaps to be traded during our test period.
-14%
-16%
Starting equity: $100,000 ($10 slippage/com- -18%
mission deducted per trade). -20%
-22%
Test data: The system was tested on the Active -24%
Trader Standard Stock Portfolio, which contains 3/3/93 1/28/94 2/1/95 1/30/96 2/3/97 1/4/99 1/3/00 1/2/01 1/2/02 1/2/03
the following 18 stocks: Apple Computer
(AAPL), Boeing (BA), Citibank (C), Caterpillar age, 100 trading days to close) was just under 11 percent. By
(CAT), Cisco (CSCO), Disney (DIS), General Motors (GM), comparison, the average loss of the 12 gaps that are still open
Hewlett Packard (HPQ), International Business Machines is a sharp -32 percent, and the average number of trading days
(IBM), Intel (INTC), International Paper (IP), JPMorgan Chase they have been open is about 350 (about one and a half years).
(JPM), Coke (KO), Microsoft (MSFT), Sears (S), Starbucks That most of the gaps in the test portfolio within the past 10
(SBUX), AT&T (T) and Wal-Mart (WMT). years have been closed reinforces the idea that gaps do have a
tendency to get filled — although it often takes a while.
Test period: January 1993 through January 2003. However, the damage done by the minority of gaps that did
not close wiped out most of the profits achieved from the
System results: A total of 62 gaps occurred during the 10-year majority of gaps that did close. This leads to the conclusion
test period. Of these, 50 (80 percent) were closed for a profit. that trading gaps on their own entails significant risk.
The remaining 12 gaps were open at the end of the test period. However, it is possible to combine gaps with other trading
The average profit for the closed gaps (which took, on aver- tools and methods. The old saying, “All gaps are eventually
closed,” may not be totally accurate, but knowing the odds are
good that a certain price target will be reached can play an
STRATEGY SUMMARY important role in a trading strategy.Ý
Profitability Trade statistics
— Compiled by Dion Kurczek of Wealth-Lab Inc.
Net profit ($): 11,942 No. trades: 62
Net profit (%): 11.94 Win/loss (%): 80.65
Exposure (%): 28.42 Avg. gain/loss (%): 2.69 PERIODIC RETURNS
Profit factor: 1.27 Avg. holding time: 148.15
Avg. Sharpe Best Worst % Max. Max.
Payoff ratio: 0.34 Avg. profit (winners): 10.97 return ratio return return Profitable consec. consec.
Recovery factor: 0.35 Avg. hold time (winners): 100.06 periods profitable unprofitable

Drawdown Avg. loss (losers) %: -31.80 Weekly 0.03% 0.16 6.56% -12.50% 49.23% 9 17
Monthly 0.15% 0.16 13.54% -9.68% 47.90% 5 6
Max. DD (%): -24.75 Avg. hold time (losers): 348.50
Quarterly 0.43% 0.15 16.34% -14.11% 53.66% 3 3
Longest flat days: 465 Max. consec. win/loss: 38/4
Annually 1.60% 0.22 10.73% -12.90% 60.00% 4 1
LEGEND: Net profit — profit at end of test period, less commission •
Exposure — the area of the equity curve exposed to long or short positions, as
LEGEND: Avg. return — the average percentage for the period • Sharpe ratio
opposed to cash • Profit factor — gross profit divided by gross loss • Payoff
— average return divided by standard deviation of returns (annualized) •
ratio — average profit of winning trades divided by average loss of losing
Best return — best return for the period • Worst return — worst return for
trades • Recovery factor — net profit divided by max. drawdown • Max DD
the period • % Profitable periods — the percentage of periods that were prof -
(%) — largest percentage decline in equity • Longest flat days — longest
itable • Max. consec. profitable — the largest number of consecutive prof -
period, in days, the system is between two equity highs • No. trades — num -
itable periods • Max. consec. unprofitable — the largest number of consec -
ber of trades generated by the system • Win/Loss (%) — the percentage of
utive unprofitable periods
trades that were profitable • Avg. profit — the average profit for all trades •
Avg. hold time — the average holding period for all trades • Avg. profit
(winners) — the average profit for winning trades • Avg. hold time (win- Trading System Lab strategies are tested on a portfolio basis (unless
ners) — the average holding time for winning trades • Avg. loss (losers) — otherwise noted) using Wealth-Lab Inc.’s testing platform.
the average loss for losing trades • Avg. hold time (losers) — the average If you have a system you’d like to see tested, please send the trad-
holding time for losing trades • Max. consec. win/loss — the maximum ing and money-management rules to editorial@activetradermag.com.
number of consecutive winning and losing trades

Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or
promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not
guarantee future results; historical testing may not reflect a system’s behavior in real-time trading.

ACTIVE TRADER • May 2003 • www.activetradermag.com 17


FUTURES
Trading System Lab
FIGURE 1 PORTFOLIO EQUITY CURVE
Gap closer The equity curve exhibits some volatility, but also an overall upward
bias and extremely low market exposure. This is a result of the small
Markets: Any. number of trades, as well as their short holding periods.
200,000
System concept: The stock Trading System Lab (p. 54) fea- 190,000
tured an experimental system designed to trade gaps. The 180,000
intention was to go long on every down gap and hold the 170,000
position until the gap was closed (if it ever closed). This pro- 160,000
vides useful information about the dynamics of gap behav- 150,000
ior. 140,000
However, it is not possible to hold a losing futures posi- 130,000
120,000
tion in a similar manner because the higher leverage in
110,000
futures results in losses of a much larger magnitude. Taking 100,000
this into account, the futures system goes long right when 90,000
price is starting to fill a down gap. The absence of resistance 80,000
in the price void of the gap should provide positive momen- 70,000
tum for a long trade. Based on the results of the stock test, it 60,000
is likely most of the gaps will be filled. 50,000
In addition, this system uses three different exits to pro- 40,000
30,000
tect capital while giving trades room to breathe. The strate-
20,000
gy uses a breakeven stop entered soon after the trade is prof-
10,000
itable to protect against a reversal. When the gap is not filled 0
and prices do not reach our breakeven level, we employ a 8/16/93 7/4/94 6/2/95 5/1/96 4/1/97 3/2/98 1/3/00 1/2/01 1/2/02
wide stop-loss order. Equity Cash Linear reg
The system should have a large number of winning and
breakeven trades, and a small number of large losses.
Because of the high expected win-loss ratio, the strategy uses an trade). All traders must weigh these considerations and deter-
aggressive maximum risk setting (10 percent equity loss per mine their personal risk tolerance when deciding on the stop-
loss and maximum risk levels.
FIGURE 2 SAMPLE TRADES
Gaps in gold trigger two trades. The green lines represent the entry points and the red lines Rules:
represent the profit-target exits. Notice how prices gapped up to close the first gap down, 1. A long entry setup occurs when there is
forming an island reversal. The second gap also closed, but not before the trade was a down gap greater than the 20-bar aver-
stopped out. Increasing the stop-loss distance would have turned this trade into a winner. age true range (ATR). Multiple open
370.00 trades are acceptable.
Gold futures (GC), daily 2. Go long on a buy stop order at the high
of the down-gap bar plus one tick.
360.00
3. Exit with a profit using a limit order at
the low of the bar that preceded the
350.00 down gap.
4. Place a stop-loss order below the entry
340.00 price that is three times the distance
between the entry price and the profit
target level.
330.00
Note: Wait until the close of the entry bar
before placing the profit target and stop-
320.00 loss orders.
5. As soon as the contract closes with a gain
310.00 of at least one percent, place a breakeven
stop to exit at the entry price.
300.00
Risk control and money management:
1. Starting equity: $100,000. Deduct $10
290.00 slippage/commission per contract
(entry and exit).
Volume 2. The number of contracts to buy is deter-
100,000
mined by calculating the distance
between the entry price and the initial
stop-loss level. Buy the number of
May 1999 June 1999 July 1999 August 1999 September 1999 October 1999 contracts that results in a maximum loss
Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com) of 10 percent if the stop-loss is hit.

18 www.activetradermag.com • May 2003 • ACTIVE TRADER


FIGURE 3 DRAWDOWN CURVE
The largest drawdown, which began in late 1999, was eliminated in
Test data: The system was tested on the Active Trader mid-2002. The system exhibits a favorable recovery factor (the net
Standard Futures Portfolio, which contains the follow- profit divided by the maximum drawdown) of 2.08.
0.00%
ing 20 futures: DAX30 (AX), corn (C), crude oil (CL), -2.00%
German bund (DT), Eurodollar (ED), Euro Forex (FX), -4.00%
gold (GC), copper (HG), Japanese yen (JY), coffee (KC), -6.00%
live cattle (LC), lean hogs (LH), Nasdaq 100 (ND), natu- -8.00%
ral gas (NG), soybeans (S), sugar (SB), silver (SI), S&P -10.00%
500 (SP) and10 year T-Notes (TY). -12.00%
-14.00%
Test period: This test used ratio-adjusted data (from -16.00%
Pinnacle Data Corp.) spanning August 1993 to -18.00%
-20.00%
November 2002.
-22.00%
-24.00%
Test results: There were a total of 69 trades during the
8/16/93 7/5/94 6/6/95 5/3/96 4/4/97 3/5/98 1/3/00 1/2/01 1/2/02
test period. This was less than the number of gaps that
occurred, but because the system enters as price begins
to penetrate the gap, there could be setups that have not trig- trades was 2.54 percent, while the average loss of losing trades
gered trades yet. Eleven of the trades triggered our breakeven was -2.65 percent. Overall, these are very positive statistics,
stop and were closed at the breakeven level. Ten trades were considering the degree to which the win-loss ratio is leaning
losers, while 48 were winners. This confirms our expectation of toward the win column.
the system’s win-loss behavior. The similar behavior of gaps in stocks and futures is inter-
Counting breakeven trades as losers, the system had a win- esting. By analyzing the behavior of gaps in one market we
loss ratio of nearly 70 percent. The average profit of winning were able to design a profitable system based on the same phe-
nomenon in a different market.
STRATEGY SUMMARY The message of this strategy is that it is worthwhile to pay
attention to gaps, especially when prices start to fill a gap. The
Profitability Trade statistics lack of resistance in the gap area can be exploited if you can act
quickly enough.
Net profit ($): 94,659 No. trades: 69
— Compiled by Dion Kurczek and Volker Knapp of Wealth-Lab Inc.
Net profit (%): 94.66 Win/loss (%): 69.57
Exposure (%): 3.07 Avg. gain/loss (%): 0.96
Profit factor: 1.79 Avg. holding time: 16.62 PERIODIC RETURNS
Payoff ratio: 0.96 Avg. gain (winners) %: 2.54 Avg. Sharpe Best Worst % Max. Max.
Recovery factor: 2.08 Avg. hold time (winners): 8.96 return ratio return return Profitable consec. consec.
periods profitable unprofitable
Drawdown Avg. loss (losers) %: -2.65%
Weekly 0.16% 0.50 15.91% -12.98% 24.28% 4 55
Max. DD (%): -25.27 Avg. hold time (losers): 34.14 Monthly 0.70% 0.52 19.31% -12.98% 36.28% 4 13
Longest flat days: 570 Max. consec. win/loss: 7/3
Quarterly 2.05% 0.52 32.62% -12.16% 52.63% 4 4
Annually 10.21% 0.55 39.42% -12.75% 77.78% 6 2
LEGEND: Net profit — profit at end of test period, less commission •
Exposure — the area of the equity curve exposed to long or short positions, as
opposed to cash • Profit factor — gross profit divided by gross loss • Payoff LEGEND: Avg. return — the average percentage for the period • Sharpe
ratio — average profit of winning trades divided by average loss of losing ratio — average return divided by standard deviation of returns (annualized)
trades • Recovery factor — net profit divided by max. drawdown • Max DD • Best return — best return for the period • Worst return — worst return
(%) — largest percentage decline in equity • Longest flat days — longest for the period • % Profitable periods — the percentage of periods that were
period, in days, the system is between two equity highs • No. trades — num - profitable • Max. consec. profitable — the largest number of consecutive
ber of trades generated by the system • Win/Loss (%) — the percentage of profitable periods • Max. consec. unprofitable — the largest number of
trades that were profitable • Avg. gain — the average profit for all trades • consecutive unprofitable periods
Avg. hold time — the average holding period for all trades • Avg. gain
(winners) — the average profit for winning trades • Avg. hold time (win- Trading System Lab strategies are tested on a portfolio basis (unless
ners) — the average holding time for winning trades • Avg. loss (losers) — otherwise noted) using Wealth-Lab Inc.’s testing platform.
the average loss for losing trades • Avg. hold time (losers) — the average If you have a system you’d like to see tested, please send the trad-
holding time for losing trades • Max. consec. win/loss — the maximum ing and money-management rules to editorial@activetradermag.com.
number of consecutive winning and losing trades

Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or
promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not
guarantee future results; historical testing may not reflect a system’s behavior in real-time trading.

ACTIVE TRADER • May 2003 • www.activetradermag.com 19