Classic Gap Fade Tactic Works Again
Dec 7, 2007: 12:23 PM CSTJust after noon Eastern, the major US indexes complete the 1, 2, 3, Gap Fade tactic, which has been working extremely well over the last few months.
As a refresher, any time a gap occurs on (especially) the Dow Jones (or DIA) that is less than 100 points, the strategy that I find that works best is the following:
- Enter short (if it is – as in this case – an upwards gap) and play for the target of yesterday’s close (with a stop about 30 to 45 points above your entry)
- If the gap does fill (price returns to yesterday’s close) then flip your position and play for a retest of the gap opening price with a stop about 25 to 35 points below entry.
- Exit at the retest only of today’s gap open price
Caveat, if your stop is hit on the initial gap-fade trade (or if price consolidates for over an hour or more) then flip your position and put on a larger position and play for a larger win (the underlying imbalance was so strong and is now expected to continue)
If your stop is hit on the second trade, there is no reason or justification to flip your position and play for a larger target to the downside. Take your stop and move on to other trades.
Let’s look at today’s action so far to see why this is a powerful and effective tactic:
I am using the DIA (Dow Jones ETF) on the 5-minute timeframe for this example.
Notice that price gapped up approximately 50 points ($0.50 on the DIA) and a short could have been entered either immediately or (conservatively) after a few bars to wait for confirmation.
Though price went against the position initially, it never reached your stop-loss level and immediately plunged on a failure test of the gap highs.
Price found support at the rising 20 period MA but found significant resistance at 13640 (or $136.40). Still, your target is yesterday’s close, which – not coincidentally – found support and could prove as today’s absolute low ticks.
When price retested yesterday’s close, enter a “long” buy position with a stop (in this case) beneath the rising 50 period moving average and play for a target of today’s gap open price (or even the intraday price high for aggressive traders) which was about 13650 ($136.50).
The target was recently achieved with little opposing force and the trade could have been exited profitably, and you captured profits on the three swings of the day so far.
Now we wait to see if continuation patterns form or momentum divergences form. Regardless, the pattern loses predictability at this point and other trades must set themselves up for entry.
Notice that the 1,2,3 Gap Fade Technique uses no indicators other than price.
Study for yourself to see if you would like to add this tool to your increasing trading toolbox.
