Quick and Instant Gap Fade

Jan 29, 2008: 10:05 AM CST

Readers know how much I enjoy gap fade trades. This morning was no exception, though it was nowhere near the magnitude of last week’s gap fades. Let’s check it out:

I’m utilizing the one-minute chart (not recommended for trading) to illustrate the point, because the 5-minute chart is too narrow to illustrate.

Gap fades are normally entered after giving the market a few minutes to shake from the overnight session, and this is a rare example of a signal to fade the gap that was, itself, faded initially, which tested the intestinal fortitude of those participating.

Notice how the market initially moved to fade the gap and traders who entered around $124.20 were targeting $124.50 with a stop a certain distance (depending on their risk tolerance) above the day’s high at $124.40. Traders who placed their stop too close (pennies above $124.40) were nicked out of their positions as the market sharply tried a bull swing but failed at that level before reversing convincingly to the downside to fade the gap unimpeded.

I like to highlight examples where expectations are temporarily thwarted, or the market moves to confuse the majority. This is such a case. You really had to put in your stop and put in your target and walk away. If you stared at the prices moving, you likely would have become frightened and exited your gap-fade (short-sell) trade quite literally at the high tick (so far) of the morning.

I have highlighted the two trades that formed as a result of this morning’s gap.

  1. The red line. Fade the gap. Sell Short and target yesterday’s close (purple line)
  2. The green line. Play the impulse in the direction of the gap (exit your short trade first with a profit) and then target the intraday highs. A stop could have been placed beneath the rising 200 period moving average on this chart, or elsewhere depending on your risk tolerance.

Just for reference, here is the same price action on a 5-minute chart, which is the smallest time frame you should attempt to trade:

Notice how price is now coming off the intraday high. I would suspect price would test the rising 20 period MA and then inflect off to retest these highs.

Gaps sometimes form the initial trigger for a trend day, but I doubt this will occur due to the announcement of the Federal Reserve tomorrow regarding interest rates. The market usually consolidates before exploding one way or the other following the announcement. The market expects a .25 minimum cut but would prefer (and actually probably expects) a .50 cut.

We’ll see!

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