Classic Gap Fade Tactic Works Again

Dec 7, 2007: 12:23 PM CST

Just 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:

  1. 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)
  2. 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.
  3. 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.

6 Comments

6 Responses to “Classic Gap Fade Tactic Works Again”

  1. Brandy Night Rocks Says:

    Is there a way to actually play this one profitably and limit the risk? I’m still pretty green, and been reading for a while, so I know you loves your gap plays, but I’m a bit perplexed on this one. A move of fiddy cent on a $135 instrument is less than four tenths of one percent, so by my calculation you’d have to put on a position of about $135k to clear $500 on the trade. At $15 or $20 total commission coming and going, you’d need to wager about $500 just to break even. Stops at 40 points off the entry additionally seem to give it a pretty poor risk-return calculation.
    Really, I love your blog and read it religiously. It’s been very instructive. I’m just wondering if I missed something here or if I’m really not getting the basic concept.

  2. Corey Rosenbloom Says:

    Brandy,

    There are a variety of ways to use the indexes to set-up trades in other stocks, and many traders will watch the major indexes closely to let them know what stocks to trade and how aggressively to trade them. For example, many ‘major stocks’ like Google and Apple and others follow the NASDAQ composite and many of the Dow Components mirror the intraday action of the indexes. So, if you get a major buy signal on the DIA or the Dow Jones itself, then go into one of those stocks with higher volatility and make a few dollars instead of 50 cents or more. Of course, that increases the risk as well.

    What I do in my own trading is use Index Futures, almost exclusively the @YM Dow-Mini. I am unable to post this price action in StockCharts.com, my preferred method of capturing and posting charts, and so I am forced to use the DIA or the $INDU itself as a proxy to demonstrate the trades I make or set-ups I find that appeal to me.

    Please refer to my earlier post on “Why I am Trading the Index Futures” for a complete explanation, but you’re right in that I do not use the DIA any longer as a vehicle to trade.

    To put it simply, two contracts of the @YM (Dow-Mini) are equivalent to 1,000 shares of DIA stock (ETF).

    To control two contracts, you need to put up just under $10,000 of margin with your futures broker.

    To trade 1,000 shares of the DIA, you would correctly need about $140,000.

    To put that into perspective, a 50 point move in the @YM equals $500 for your account. A 100 point move (or two 50 point trades each) equals $1,000. Not bad for a day’s work. I trade for consistency, not immense riches, and I am quite risk averse. Stated differently, a 100 point move in a $10,000 futures account is actually a 10% return. I tend to focus more on dollar returns than percentage returns, however.

    For me (TradeStation is my broker), the commission on 1,000 shares is $8.00 per side, compared to two futures contracts at $5.00 per side. Not a major difference, but it adds up when you’re trading larger positions.

    And in regards to risk/reward, if a trade has a probability of hitting its target at 70% to 80% (not that gap fades do, but they do have greater than 50% odds of achieving the full target), then it is perfectly acceptable to risk 30 to 50 points to achieve a target of 50 points on balance. You’re playing only for one to one (risk to reward) but that’s fine because the edge comes from the high probability trade set-up.

    This is just a basic explanation so let me know if you need me to go into more detail.

    Thanks for the comment!

  3. DannyBly Says:

    Nice post – while I was trading the bund the market would almost always try to close the gap if there was a gap opening…

  4. Trader Mom Says:

    Great info. Good Strategy.

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