Gap Trades Page 2
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Understanding The Odds (page 2):

Trading The Opening Gap in the Mini Index Futures Contract


Just before market open it is also a good idea to mark on our intraday chart the price high and low points that occurred in overnight trading (all trading activity that occurred since the prior day close). If market activity is thought of as an auction process, where bidders and sellers are constantly vying for the most advantageous price, overnight highs and lows represent the outer extremes of accepted value for that particular period of time. The highest price achieved represents the maximum that buyers were willing to offer, and the lowest price represents the minimum that sellers were willing to accept. For this reason, subsequent price action has a tendency to remain within the boundaries of apparent value as defined during this period. If these limits are exceeded to the upside, we know that current market activity has a bullish tone to it. On the other hand, any downside push that surpasses the overnight low has bearish implications.

As the market nears its opening bell, and actual gap size is better known, we then concentrate on a set of statistics that describe the odds of price returning to the prior day closing level. Using gap level historical price information, market-specific probability of closure can be calculated and displayed as a known value just prior to the beginning of each trading day (chart below). This information is dependant on the direction and size of the gap, and can tell us what the chances for full closure happen to be along with the odds of half-gap closure (which are always greater than full closure). We can also determine the probability of closure based on the current day of the week, as well as note any other significant variables that may effect the probability of gap closure (such as special precautions necessary on the day after Options Expiration Friday or on "first Friday" Employment Report Days).

With this information in hand, and assuming the gap size is tradable with a high probability of closure, we can then begin the day with an eye towards placing a trade in that direction. Some of the variables that are best monitored just prior to placing a gap trade are (1) price action relative to significant support and resistance levels (i.e., regular session highs and lows established on each of the prior two trading days), and (2) NYSE Tick readings as a sign of short term trend exhaustion. It is especially important to measure the market's current state of expansion/contraction. Is the market currently trading in an ever-tightening range, or has it instead just begun a strong move in a direction opposite gap closure? An indicator called the "Volatility Expansion Meter", referred to as "Vol-X" in the chart below, can tell us when, and in which direction, a big move is likely to begin. If Vol-X is firing a signal in the opposite direction as gap closure, we definitely do NOT want to place a trade in the direction of gap closure. Rather, we would want to be looking for a trade in the same direction as the gap. Although a detailed explanation of Vol-X is outside the scope of this article, the standard application of Bollinger Bands can provide a similar, although less precise, glimpse into these kinds of internal market dynamics.

As an example, please refer to the chart below, which depicts an opening gap trading opportunity in the Dow Jones Mini contract. The indicator in the top left screen reports gap size, direction, and accompanying statistics prior to and at the moment the market opens (all time references are basis the Central Time zone). This indicator tells us that the odds for closure are high, and that we want to look for an early opportunity to get long. The "Leading Market Sectors" chart directly below the gap statistics display tells us that the three sectors that often lead market activity are starting the day with a definite bullish bias, adding even more reason to be on the long side. In the large one-minute candlestick chart we can see that "Vol-X" has not fired a signal to the short side, which indicates that range expansion lower is unlikely. Perhaps the most significant factor affecting our decision to take this trade is that the NYSE Tick reading ($TICK) is unable to muster any momentum to the downside. In fact, it can't even break down through the zero level. The rise in Tick readings is our trigger into the trade, which gets us in a few points before the 10397 level of Today's Open is breached. A protective stop is placed just below the closest known support zone, which is that of S2 at 10384.

Charts created using TradeStation. ©TradeStation Technologies, Inc. All rights reserved.
No investment or trading advice, recommendation or opinions is being given or intended.

The market moves in our favor in rapid fashion, finding only temporary resistance along S1 and YYL (the daily low two days prior to today's trading). The Half Gap Fill line is quickly surpassed as the market moves on to reach the Full Gap Fill target of 10428. The trade nets a total of 33 points, or $165 per contract less commission and fees. It is also worth pointing out that the market made a short term bounce away from this level once the gap was filled. This is a common occurrence. A stop and reverse placed at the gap fill level can often garner a few extra points of profit. Again, NYSE Tick readings can confirm the reversal point as well as serve as our exit trigger.


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