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 7^th: 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 6^th, 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 19^th: FAILED Gap Fade

October 19^th 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 23^rd: 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)

Inter-market relationships are seemingly following their script. Interest rates are declining (bond prices are rising), commodities are rising, and the dollar index is declining.

There has been absolutely no relief for the US Dollar Index, and it has continued to make new lows. Today, we registered a new momentum low, which indicates slightly higher probabilities that a new price low is yet to come.

Let’s look at the chart (Daily View):

Weekly View:

Both the daily and weekly charts show extended and pronounced downtrends (lower lows and lower highs).

The orientation of the major moving averages is in a ‘total bear’ position (the 20 EMA is below the 50 and both are a comfortable distance below the 200).

The most recent ’sell swing’ in the index has been particularly harsh, meaning a reaction up isn’t too far outside the realm of possibilities, but it would likely be a relief rally only, because the structure of the trend orientation is so biased to the downside.

Falling dollar prices are a boon to commodities, and rising commodities typically are indicative of inflation, which tends to be rather bearish for the Stock and Bond Markets, because the Federal Reserve typically acts to counter inflationary pressures by raising interest rates.

Closely watch the bond market, stock market, commodity indexes, and the US Dollar Index for potential signs and for longer term posturing (or positioning).

Gary at The Smart Money Tracker posted an excellent observation that is one of the basic tenets of technical analysis: The Larger the Consolidation Period, the Larger the Move out of Consolidation.

This concept is based in the Fourth Principle of Price Behavior which states that “Price Alternates Between Range Contraction and Range Expansion.”

Price consolidates to an equilibrium level where both buyers and sellers are comfortable at those levels, and a sudden impulse unhinges the balance and creates a sustained trend move.

View Gary’s article for helpful charts and a deeper explanation of why this phenomenon might work.

Traders can often find ’sleeper stocks’ that offer great potential for profit by running sector and industry scans and determining which industries have been showing greater relative strength or weakness over a specific period.

The following results are from a three-month industry group scan from Prophet.net (the graph dates are read right to left in terms of money flow/strength):

Strangely perhaps, Regional Banks have been showing the largest gains/relative strength over the past three months, with three weeks in a row at the top spot.

Major airlines and Independent Oil and Gas have shown high relative strength as well, and these industries are significant because of the number of stocks within those groups (111 stocks in Regional Banks and 92 in Oil & Gas).

Potential opportunities may still be available in the following Regional Bank Stocks: CBH and STT. Personally, I would avoid this industry.

Money has been consistently flowing into the Internet Information Providers group with 38 stocks, as we have seen relative strength readings of 44 in August to 98 currently. There are probably some choice opportunities as this group continues to take the lead. You often find better opportunities in groups that exhibit this pattern of flow, rather than those that have been at the top for multiple months.

Opportunities for long trades may be found in the following stocks that are currently in uptrends: APA, APC, CHK, CNQ, DNR, DVN, EAC, EOG, and ECA.

Relative strength is based on the concept that “What is strong, gets stronger.”

The opposite of relative strength is relative weakness. Let’s see the chart of the worst performing industries over the last three volatile months:

It probably should come as no surprise that the worst performing industries include Home Improvement, Mortgage Investment, Building Materials, Residential Construction, and Heavy Construction.

The housing market has been the focus of the media for months in terms of the ‘credit crisis’ and sub-prime ‘meltdown’ or whatever buzz-word is in vogue at the moment. The point is that these industries have seen the largest money flows out of them, and have exhibited the weakest relative strength ratios over the last few months.

Again, the best opportunities (to ‘go short’ or hedge) are often when we see a right to left pattern of green to yellow to red, which none of these industries are showing neatly.

It’s that time of year again!  The Money Show is hosting its annual winter Trader’s Exposition (one of three) in Las Vegas from November 15-18 at the Mandalay Bay Casino.

Rather than explain all about it, I wanted to direct you to a post by the Trading Goddess summarizing the conference.

The official link is here at the Las Vegas Trader’s Expo.

I will be attending and am looking forward to it, and can’t wait to meet other traders there and learn from them.  Some of the most valuable information and connections occur in the hallways and dining areas at the expo, but these connections are one of the most overlooked aspects of the whole convention.

Talk to others and learn what works from them or where they are in their trader development and make some new connections.

I hope to see some of you there in Vegas!