Gap Down into Positive Divergence

Mar 31, 2008: 9:42 AM CST

The Dow Jones Index this morning (along with the S&P 500) formed an ideal ‘gap fade’ play which then set up a positive momentum divergence. Let’s see the chart and figure out how we could have taken advantage of this situation.

The overall structure is in a strong downtrend, but the most recent price swings have created a momentum divergence which often limits further bearishness. Keep in mind this is the 5-minute chart, which is very short term in nature.

Nevertheless, let us see the two trades that set-up via the morning gap and how we could have played them.

Chart zoomed in:

First, when there’s an overnight gap (of less than 100 Dow Points), odds favor a close of the gap, so your first trade would have been to buy to target yesterday’s close. I often give the market 10 to 15 minutes to shake out the excess of the overnight session (especially on Mondays) which actually can give you better entry positioning.

For me, I place a stop ½ my target, so in this case the target was about 40 points ($0.40 in the DIA) so my stop would have been 20 points ($0.20).

I don’t care that the price exceeded the open for my exit, I just offer my position there (using a bracket strategy) and exit.

Once the gap is filled (this one filled very easily) then I often shift to find an area to play the impulse back in the direction of the gap (get ‘short’ in this case). I would expect resistance to come from the declining 50 period moving average (we didn’t even make it there) and so I would place my stop there (again, about 20 points or $0.20 from entry) and then play for the morning’s opening price (about $121.80).

This trade also worked out quite nicely with minimal distraction.

That makes two simple trades you could have taken with high odds this morning that provided minimal risk and were created using the price structure only (I added the moving average for confirmation).

At this point, the positive divergence could limit further downside movement and cause the market to consolidate or actually reverse back to the upside on this time frame. It wouldn’t surprise me to see the market go higher from here, actually but always following the developing structure for new clues throughout the day.

1 Comment

One Response to “Gap Down into Positive Divergence”

  1. Anonymous Says:

    Great analysis of a gap fade trade. You can see my somewhat similar setup tactics and logic at: http://bzbtrader.blogspot.com/2008/03/tuesday-fade-open-lesson.html