How to Play Opening Gaps in the Indexes

Nov 8, 2007: 12:05 AM CST

Ever wanted to know what to do when there’s a gap up or gap down in the US Indexes? Here is a type of strategy that can help you add profits and clarity when this situation occurs.

Here are the general rules for Index Gap occurrences:

  1. The first play should be to “fade” the gap (buy down gaps or sell up-gaps) [Target: Yesterday’s close]
  2. The second play should be to enter at the gap fill in the direction of the gap (buy a closed gap-down or sell-short closed gap ups) [Target: Today’s open]
  3. If the gap FAILS to close (price stalls or makes no effort to fill) then take a stop and then trade aggressively in the direction of the gap [Target: Often Unknown]

Gaps are a sign of impulse, and it is often profitable to enter after the first retracement following a price or momentum impulse.

Gaps are unique, in that a pure trade can be created simply by playing (trading) to fill (or fade) the gap. Once the gap is filled, one can enter a second ‘pure price’ trade in the direction of the initial impulse.

Nothing is ever 100%, and neither is this strategy, but it allows you to throw all indicators out and simply trade off price.

Of course, the larger the gap, the lower the odds of it being filled initially. The smaller the gap, the greater the odds of being filled. All examples imply day-trading tactics are used.

Let’s look at some quick examples using the DIA (Diamonds ETF for the Dow Jones Index):

November 7th: FAILED gap Fill

The first play was to enter long (buy) to close the gap. When price consolidated and could not close by the first hour or more, odds favor taking your stop, scratching (exiting) the trade for a small loss, and then trading aggressively (perhaps on leverage) to the downside (short-selling). This would have been extremely effective.

November 6th, SUCCESSFUL Gap Fill

This is a “Textbook” pattern.

Enter short to play to fill the gap. Once the gap is filled, enter long and play at least for a retest of the morning’s open. Odds would have favored playing for a larger target, which was achieved at the close.

November 5th: PARTIAL FILL Gap Play

This was truly a nauseating day. The large gap down creates doubts that the gap would fill early on, and actually it did not, but was filled into the close with the textbook fill and reverse pattern.

Nevertheless, the first play is to fade the gap, which would mean buying the DIA. The gap only filled halfway, but the consolidating and rotating price action (complete with head and shoulders pattern) would have allowed you to exit with a profit. As price churned and prepared for a swing down, a short-sell trade could have been entered to play for the morning’s open, which was exceeded before reversing sharply to the upside. This swing up in price actually filled the morning’s gap, but there was little evidence at this point to play for that target. Doing so would have been a relatively low probability trade. That move was news related.

October 19th: FAILED Gap Fade

October 19th was a particularly devastating day for the US Indexes. The large (100 point) gap still offered a play to fill the gap, which was forcefully stopped out. As price rotated mid-day and formed a slight bear-flag, odds would have favored a short-sell position for two reasons: The fact that the morning gap could not be filled AND the prospect of a “measured move” due to the Bear Flag formation. Nevertheless, the afternoon short-sell was wildly profitable.

October 23rd: SUCCESSFUL Gap Fade

If there ever were a textbook “Gap Fade” or “Gap Fill” pattern, this would be it.

The early morning gap called for the first play of the day to short the DIA back to yesterday’s close. Price behaved accordingly well. The second play would have been to trade long in the direction of the initial impulse following the retest of yesterday’s close. The long trade would have experienced numerous small retracements, but ultimately price closed on the highs of the day.

Conclusion:

Knowing what to do when a gap occurs can not only provide calm to your day, but can help you trade effectively and profitably.

If price is ‘expected’ to fill the gap and it does not, then that often sends a more powerful signal in the opposite direction which still frequently leads to a profitable trade even if your initial trade was a stop (think of it as ‘paying up’ for valuable information).

We can never know if an index gap will close or not, but we can be prepared and trade according to the probabilities given to us by basic price behavior.

(All charts created with TradeStation and are 5-minute charts)

7 Comments

7 Responses to “How to Play Opening Gaps in the Indexes”

  1. yo Says:

    This was a very nice analysis. It’s one of the first that daytraders have traditionally learned, and very valuable insight as to how specialists and market makers are likely to position themselves.

  2. chuck Says:

    I am a hit-and-run trader. I have designed a formula that looks at premarket hours versus the previous day’s low, high or close in percentage differences.

    Do not have any problem picking some great stocks.

    Let’s say I have a 10% gap down from the previous day’s low in premarket hours.
    Looking for some type of entry system for a short position after the market has opened up.

    Usually I am out of the market by 10 o’clock AM.

    Any help appreciated, Chuck

  3. chuck Says:

    Update to the previous post. I always use a five minute chart.
    Chuck

  4. Corey Rosenbloom Says:

    Chuck,

    Thank you for your comment.

    Briefing.com also has a ‘gap scan’ as does StockCharts.com, and I can scan using simple parameters in a RadarScreen in TradeStation.

    Try comparing the range of today’s (gapped) 15 minute bar or even 30 minute bar to those of the last 7 or more days (visually, or with a formula). If today’s range has greatly exceeded prior day’s opening bars, then odds favor continued trend (or price movement) in the direction of today’s expansion in price.

    I typically avoid stocks that gap up or down more than 5%, as the momentum imbalance (or supply/demand imbalance) is SO great that there may not be a possibility of a gap fade or close. In those cases, it’s usually best to go ahead and play in the direction of the gap.

    And sometimes gaps can’t close within 30 minutes or an hour. Sometimes it takes a little longer than 10:00am. You may have to trade a little longer.

    Also, when a gap of less than 2% closes early, then odds favor playing in the direction of the gap (reversing the fade) to (at least) retest the gap open, which sets up a second trade.

  5. Kailash Says:

    I have a stock that gapped up almost 5 % and faded partially down to 2.5% and then reversed and made a new high. I just held my short thourgh the run up and it has now come down to above the gap open price. Can this action fill the gap in the next two days, though not today? I don’t mind holding my short for a few days. Any help is appreciated. Thanks.

  6. Kailash Says:

    The stock described above is TASR on Feb 12,2008. I shorted it at 11.53 and still holding for a multiday play.

    Kailash

  7. Rahul_bk Says:

    Hey chuck can u elaborate on the method..???