Gap Trading Techniques

1. Morning Reversal Strategy

2. Trading The Overnight Gap

3. Trading The Opening Gap

12

4. Gap Closer

16

TRADING Strategies

Morning REVERSAL strategy

Historical tests reveal the tendency of the major stock indices to revert to the
previous days closing price in the early minutes of the trading session. This
strategy takes its cue from that bit of market behavior.
BY BRYAN C. BABCOCK AND ARTHUR AGNELLI

inding a strategy that backtests successfully is rare; finding one that is reproducible in
live trading is rarer still.
The following intraday strategy the
Morning Gap Reversal (MGR) capitalizes on the major indices tendency to
retrace toward the prior days close each
morning. It has a high winning percentage
tested in both bull and bear conditions
an important characteristic for any shortterm strategy and it is easy to execute.
Each morning the opening price of an
index or stock is higher or lower than the

prior days closing price. This price

change is called the morning gap if it is
above the previous days high (an up
gap) or below the previous days low (a
down gap). However, for simplicity,
we will use gap to refer to the distance
between the previous close and current
open, regardless of whether or not the
open falls within the previous days
range (see Figure 1).
First, we will analyze the behavior of
morning gaps to determine if they provide a logical basis for a trading strategy.

Morning gap statistics

Statistically, price has a very high likelihood of filling between 50 and 100 percent of the gap between yesterdays
close and todays open during the trading day. Usually, a reversal that fills (or
partially fills) the gap will occur within
the first 30 minutes of trading (by 10 a.m.
ET).
Three years of back-testing from
January 1999 to January 2003 on the
Dow Jones Industrial Average (INDU),
S&P 500 (SPX) and Nasdaq 100 (NDX)
indices was conducted to verify the statistical reliability of the basis for the
MGR strategy. The analysis was
FIGURE 1 MORNING GAPS: REVERTING TO THE CLOSE
divided into three parts: first, deterIn the first half-hour of the trading session, the market will frequently retrace in
mining the frequency and extent of
the direction of the previous days close.
morning gap reversals; second, finding out how quickly morning gaps
S&P 500 index-tracking stock (SPY),
88.97
reversed; and third, identifying
one-minute
88.92
important
time markers within
88.88
the reversal period.
88.84
88.80
Table 1 summarizes the first part
88.76
of the analysis. The columns show
Market open price
88.72
different gap sizes, from 1 to 3 per88.68
cent (positive or negative). The rows
88.64
88.60
show what percentage of the gaps
88.56
were filled, and the cells show how
88.52
often
they were filled (at some point
88.48
during the trading session).
88.44
Reversal
88.40
The table shows 85 percent of the
88.36
gaps between zero and 1 percent in
Gap up
88.32
size (positive or negative) closed at
88.28
least halfway, and 78 percent of the
88.24
88.20
gaps closed between 90 and 100 per88.16
cent.
88.12
Although slightly less reliable,
Prior day close
88.08
gaps between 1 and 2 percent (posi88.04
88.01
tive or negative) showed a similar
1/22 15:40 15:45 15:50 15:55 1/23 9:35 9:40 9:45 9:50 9:55 10:00 10:05 10:10
tendency to be partially retraced or
Source: Great-Trade by Protrader
2

www.activetradermag.com May 2003 ACTIVE TRADER

filled. These gaps retraced by at least

half 78 percent of the time and retraced
between 90 and 100 percent 62 percent of
the mornings studied. Gaps in the 2- to
3-percent range were somewhat less
likely to be filled.
Only 14 percent of the gaps (in the
Overall column) closed between zero
and 9 percent, which includes those
mornings when price immediately
moved in the opposite direction of the
gap closure, creating what is known as a
gap and run.
The second part of the analysis
explored how quickly gaps reversed.
The gaps typically closed half way (50
percent) by 9:55 a.m. Of the gaps that
closed completely, 67 percent of them
did so in the first 30 minutes of the trading session, and 86 percent closed by the
end of the first hour of trading (10:30
a.m. ET). The likelihood of additional
closure declined substantially after the
first hour of trading. Gaps that were still
open after 60 minutes closed only 4.5
percent of the time. Also, the success rate
diminished on days when economic
news was released 30 minutes after the
market open, at 10 a.m. ET.
The third portion of the analysis identified important time markers during the
gap-reversal period. Figure 2 (below)
shows the typical time markers for gap
reversals. Just after the open, the major
indices tended to continue to move in the

TABLE 1 MORNING GAP ANALYSIS

direction of the
The columns show morning gaps of different sizes.
opening price for
The
rows indicate how much of the gaps were filled.
the first one to 10
minutes. After
Gap size
this initial rally
%
of
gap
closed
+/-1%
+/-1
to
+/-2%
+/-2 to +/-3% Overall
(or sell-off), the
0-9
12
8
19
14
market turned
and began to
10-19
0
2
5
2
close the morn20-29
1
6
5
2
ing gap. This
30-39
1
4
6
2
reversal, on aver40-49
1
2
5
1
age, began six
50-59
2
5
2
1
minutes after the
60-69
1
7
4
2
open, at 9:36 a.m.
70-79
2
1
4
2
ET. The typical
80-89
2
3
2
2
reversal
was
90-100
78
62
48
72
maximized
at
50%
85
78
60
79
9:53 a.m. ET.
An approximately
fourminute countertrend move (or jig,
futures quotes are also available through
which often fakes out traders into coverthe Chicago Mercantile Exchange Web
ing positions early) typically occurred
site, www.cme.com.) Whether these conaround 9:42 a.m. and lasted until approxtracts are trading up or down in the early
imately 9:47 a.m.
morning can give you an indication of
the possible direction of the stock market
Before the bell:
open.
Pre-market review process
Second, make note of how the futures
The first step in trading the MGR is antic- are affected in the pre-market by any
ipating the direction of the opening
economic reports released at 8:30 a.m.
move. Usually two hours before the marET. This will indicate whether the
ket opens a reliable gap can be identified futures are strengthening or weakening
by checking the pre-market stock index
in pre-market trading. Make a final
futures quotes on CNBC or Bloomberg
check of the futures at 9:10 a.m. (20 min TV. (Minute by minute pre-market index
utes prior to the market open).

FIGURE 2A MORNING UP-GAP TIME MARKERS

FIGURE 2B MORNING DOWN-GAP TIME MARKERS

The primary time milestones in early trading show the

retracement to the previous close typically maximizes
around 9:53 a.m.

The time markers for the typical down gap are the same
as those for up gaps.

Morning open up gap

Prior day
closing price

Morning peak on average

9:36 a.m. EST

Trade is maximized
9:53 a.m.

Price jig usually

9:42-9:47 a.m.
Trade is
maximized
9:53 a.m.

Prior day
closing price

Morning open down gap

ACTIVE TRADER May 2003 www.activetradermag.com

Price jig
usually
9:42-9:47 a.m.
Morning bottom
on average
9:36 a.m. EST

FIGURE 3 PATTERN ENTRY

One way to enter a trade is to wait for two consecutive bars that close lower than
they open (in the case of a downward reversal and potential short trade), with the
second bar also having a lower low than the first bar

The pattern entry approach waits

for the market to reverse toward the
previous closing price before entering the trade. The trade is taken only
after
two complete one-minute bars
88.97
S&P 500 index-tracking stock (SPY), one-minute
in the direction of the reversal (i.e.,
88.92
bars with closes below their opens,
88.88
88.84
and the second bar with a lower low
88.80
than the previous bar, if the reversal
88.76
direction is down), as shown in
88.72
Figure 3). The advantage of this
88.68
approach is that by waiting for the
8
8
.
6
4
Pattern entry:
88.60
market to confirm the reversal prior
consecutive bearish
88.56
to entry, the trader avoids entering a
one-minute bars in the
88.52
losing position on days when the
direction of the reversal.
88.48
market keeps running in the direc88.44
tion of the opening gap. The disad88.40
88.36
vantage is that the trader is always
88.32
late getting into the market and may
88.28
miss significant profits as a result.
88.24
The staggered entry combines the
88.20
first two approaches by breaking
88.16
88.12
the entry into two equal halves. The
88.08
first half of the trade is placed at 9:31
88.04
a.m. and the second half of the trade
88.01
1/22 15:42
15:46
15:50
15:54
15:58
16:02
16:06
16:10
16:14
16:18
16:22
16:26
1/23 9:32
9:36
is entered after two bearish oneSource: Great-Trade by Protrader
minute bars in the direction of the
reversal. This way, if the market
reverses quickly, the trader has a
There are two qualifications for the open just above established support.
partial position already in the market.
behavior of the futures in pre-market
Both indices and stocks exhibit the
However, if the market runs in the directrading. First, all three index futures con- morning gap characteristics outlined
tion of the open, only half the trade is
tracts (S&P, Nasdaq 100 and Dow) must here. Index-tracking stocks such as
exposed.
trade consistently in the same direction QQQ, DIA, or SPY are good vehicles for
during the pre-market. For example, if
trading the MGR strategy because, not
Stop placement
the Dow futures are down 35 points at 8
being subject to the up tick rule, they are
a.m. and rally to trade up 20 points by 9
easier to sell short than individual equi- Every traders primary focus should be
a.m., they have changed from implying a ties. For these reasons, it is recommend- controlling risk and losses. Most traders
are quick to take a small profit when the
down opening to implying an up opened that you concentrate on the three
market is willing to give a larger profit,
ing. This kind of behavior should not be major index-tracking stocks when tradwhile at the same time they expose themtraded. Similarly, if one contract is up ing the MGR strategy.
selves to too much initial risk and are
and the other is down (e.g., the Nasdaq is
slow to take losses. The following guideup 5 and the Dow Jones is down 15), it is Trade entry
lines are designed to let the market connot a good day to use the MGR strategy.
The average reversal start time is 9:36
trol your profit while you control your
Second, because a very narrow gap a.m., which means the trade-entry winrisk.
reduces profit potential, gaps in the
dow is generally from 9:30 to 9:42 a.m. If
The strategy uses three kinds of stopfutures contracts must be in excess of 5 a position has not been initiated by 9:42
loss orders, the sizes of which are
points for the S&P 500 futures, 10 points
a.m., no trade is taken for the day. Three
intended for SPY, DIA and QQQ. The
for the Nasdaq 100 futures and 20 points entry techniques can be used with the
first type is the high-low stop. The
for the Dow Jones futures.
MGR strategy: time entry, pattern entry
primary risk in an MGR trade is the
and staggered entry.
market will continue to run in the direcOther factors
A time entry consists of playing the
In addition to watching pre-market trad- averages by entering a trade at 9:36 a.m., tion of the gap. Therefore, if the indexing activity, evaluate the support and regardless of what the market is doing at tracking stock trades 15 cents above the
highest high of the morning (for up
resistance in the market you intend to the time. This approach has the advantage
gaps) or below the lowest low of the
trade. Be aware of the projected opening
of being easy to execute, but it also runs
morning (for down gaps) after 9:45 a.m.,
price of the security relative to any sigthe risk of putting you immediately on the
the position should be closed. This is the
nificant support or resistance levels.
losing side of the market. Despite these
worst-case scenario and will yield the
Often a market that is gapping up will disadvantages, a trader without a realstrategys largest losses.
open just under an established resistance time trading setup system may prefer this
The second stop-loss is a trailing stop
level; a market gapping lower might method because of its simplicity.
4

www.activetradermag.com May 2003 ACTIVE TRADER

that requires evaluating where the

FIGURE 4 SHORT-TRADE EXAMPLE
trade is relative to the best price it
In this case, the entire morning gap was filled in the first 20 minutes of trading,
has experienced up to that point.
at which point half the trade was liquidated and a 25-cent trailing stop was used to
First, once a 25-cent profit has been
protect the remainder.
reached, move the stop to
breakeven. When a 35-cent profit
84.274
Dow Jones Industrial Average index-tracking
Initial stop-loss is placed at the
is in place, trail the stop-loss 25
84.20
stock (DIA), one-minute
morning high plus 15 cents
cents above the highest high (for a
84.16
8
4.12
short trade) or below the lowest
84.08
Pattern
entry
84.04
low (for a long trade) reached dur84.00
(Two consecutive one-minute
ing the trade.
83.96
bars
in
the
direction
8
3.92
For example, if the position is
83.88
Exit remainder of
of
the
reversal)
83.84
up 35 cents and moves back to
position at 9:55 a.m ET 83.80
being up only 10 cents, exit the
83.76
(83.47)
Entry:
83.72
trade; if the position is up 50 cents
8
3.68
Price 83.74
83.64
and moves back to being up only
Time 9:37 a.m. ET
83.60
25 cents, exit the trade. This
83.56
83.52
approach continually moves the
83.48
83.44
stop in the direction of the trade.
83.40
The third stop is the time
83.36
83.32
stop. Because this strategy is
83.28
8
3.24
most successful in the first 30 min83.20
utes of trading (and because eco83.16
83.12
Exit 50 percent of the position (at 83.24) when
nomic announcements often occur
83.08
the entire morning gap is closed.
83.04
at 10 a.m. ET), the time stop liqui83.01
1/22
15:30 15:35 15:40 15:45 15:50 15:55 1/23
9:35
9:40
9:45
9:50
9:55
10:00
dates any position that is still open
at 9:55 a.m.. This allows the trader
Source: Great-Trade by Protrader
to take advantage of the most benHowever, when the gap closes entiretechnique could have been used.)
eficial time period without exposing the
ly before 9:55 a.m., half the position
The market continued to move lower,
trade to the volatility of adverse reacshould be closed. (The prior days close first reaching the 25-cent profit level at
tions to news.
is a natural resistance/support level; if it approximately 9:41 a.m., at which point
In actual trading, the majority of losing trades are stopped out with a loss of is penetrated, the possibility of a turn- the stop is moved to breakeven. Next,
around off that level emerges.) The sec- DIA reaches the prior days closing price
50 cents or less. In tests, a 50-cent
ond half of the position should be kept around 9:48 a.m. When this target was
absolute stop in the SPY and DIA was
open in case the market continues to
reached, 50 percent of the position was
rarely hit. The lower price of the QQQ
move profitably.
closed for a 50-cent profit.
made them even less susceptible to being
Finally, the jig mentioned in the staFrom this point onward, the balance of
hit; the typical maximum loss in the
tistics section occurs quite frequently
the position would be exited with the 25QQQ is closer to 30 cents than 50 cents.
between 9:42 and 9:47 a.m. ET. Because cent trailing stop or at 9:55 a.m., whichevthis countertrend move can fool a trader
er comes first. In this case, the time stop
Position sizing
was reached, closing the second half of
Correct position sizing will enable you into closing a position too quickly, try to
to focus on the strategy without being avoid closing a position during this time the trade at $83.47 for a 27-cent profit. The
frame. Stick to your original stop-loss trades total profit was just over 38 cents,
distracted by unnecessary anxiety. A
levels.
taking into account the two exits.
conservative
money
management
benchmark is to risk no more than 2 perStatistical foundation
cent of account equity on a trade. This Trade example
Figure 4 shows the Dow Jones Industrial and tight risk control
means a trading account of $25,000
Average tracking stock (DIA) opening The MGR strategy is based on the favorcould afford to risk $500 per trade
higher (on Jan. 23, 2003) than the precedable statistical performance of early
($25,000 x .02 = $500). Because this strategy typically stops out a losing trade ing close, setting up a potential short morning reversals back to the previous
days closing price. It combines a high
within 50 cents of the entry, its possible sale.
Using the simplest entry approach, a
winning percentage with conservative
to trade up to 1,000 ($0.50 x 1,000 = $500)
short trade was entered at 9:37 a.m. ET at
risk management.
shares.
$83.74 (the market was already starting
The strategys simplicity makes it
to retrace toward the previous closing
easy to monitor and paper-trade in
Caveats
price of $83.24). The initial stop-loss was
real-time, which lays the groundwork
The stop-loss rules are structured to let
placed at $84.07, which corresponds to for actual trading.
the market determine how large the
profit should become when the trade the morning high plus 15 cents. (The
chart also shows where the pattern entry For information on the authors see p. 12.
runs in the desired direction.
ACTIVE TRADER May 2003 www.activetradermag.com

TRADING Strategies

Trading the overnight

With increasingly reactionary markets

GAP

comes the higher risk of opening gaps.

Learn how to spot the early warning signs
and how to take advantage of them.

BY DAVID S. NASSAR

n todays markets, many stocks

can have large supply-demand
imbalances at the opening bell.
Often, these imbalances result in
what are known as gaps, when the opening price is higher or lower than the preceding close.
News, in various forms, is generally
the catalyst for gap openings. The most
common type is macroeconomic news
such as FOMC meetings, the release of
economic indicators such as unemployment or the Consumer Price Index (CPI),
or stock-specific news such as earnings
surprises or analyst upgrades or downgrades.

When buying interest exceeds selling

interest, the gap will obviously be to the
upside and vice versa. However, what is
not known is the price level at which the
stock will open, and the precise risks
associated with being long or short in a
particular situation.
Until recently, these price levels were
often determined exclusively by large
off-floor markets, such as Instinet, an
institutional trading network that was
the first outside-market-hours trading
medium. Today, with the advent of
many other Electronic Communications
Networks (ECNs), there are many more
retail traders active in pre- and postmarket trading. However, even though
the public has access to the pre-market,
the levels that trade pre-market are still
mostly influenced by market makers
who bid or offer stock at price levels
away from the previous days close
when imbalances appear in their automated systems.
Because many of these imbalanced
orders are market on open orders
(meaning they are to be executed at the
best available price as soon as the mar-

ket opens), market makers have an

incentive to open a stock at extreme levels directly correlated to the imbalance.
This simply means that if an imbalance
is on the demand side, and a given stock
is going to open strong, market makers
will open it as high as they can, taking
the opposite side of the trade on open
buy orders.
Because most members of the public
trade only the long side of the market,
many unsuspecting amateurs buy into
gap-up openings at what often will be
the high price of the day. As a result, it is
worthwhile to explore the possibility of
trading situations when a gap will not
hold (reverses), rather than those
instances when the stock follows
through with a move in the same direction. Whether the stock reverses and
closes the gap or follows through in the
same direction, this move is perhaps the
strongest indication of what the trend
will be for the stock shortly after the gap
opening. In the example of bullish gaps,
stocks that fail to meet new highs from
the opening levels will have a greater
likelihood to retrace and lose much of

The first clue that a stock is ripe for a gap opening

is an increase in volume over its normal daily average.
6

www.activetradermag.com March 2001 ACTIVE TRADER

FIGURE 1 CHARGING LOWER

Starting in September 2000, the uptrend in Intel (top chart) came to a halt,
punctuated by a series of downside gaps. Typically viewed as a blue-chip stock
free of extreme volatility, Intel became much more volatile after the first
down gap; it became a "charged" stock that propelled the entire semiconductor
sector lower (bottom chart).
the opening gap.
Conversely, stocks that remain
strong and trade to new highs after the
opening gap will have a greater likelihood of following through and trending higher. While this shouldnt be
interpreted too rigidly (there are other
indicators to monitor, such as index
strength and sector strength, etc.), it is
the strongest single indication of how a
stock will trade following a gap opening.
Regardless of whether gaps are to
the upside or downside, it is important
to study the impact they have on
stocks. The following components and
considerations are most important
when trading gaps:

Intel (INTC), daily

75
70
65
60
55
50
45
40132
39
35
300,000,000

Volume

200,000,000

28

Charged stocks/sectors;
Volume and volatility;
Chaos and over-activity;
High risk (elasticity).

5
Sept.

11

18

25

2
Oct.

16

23

30
Nov.

13

1200.00
1150.00
1100.00
1050.00
1000.00
950.00
900.00
850.00
800.00
750.00
700.00
651.22

PHLX Semiconductor Sector Index (SOX), daily

Lets look at each of these factors.

Where the action is:

Charged stocks and sectors
Once a sector is in the public eye, think
of the component stocks as being
pumped up or charged. When this
occurs, the volume in the stock will
increase, and there will be a tremendous swing in the trading range from
one session to the next, either to the
upside or downside. Before the opening bell, in the absence of actual trade
activity, market makers will predict
price pattern changes either slightly
before an event or immediately after one
and bid the stock higher or lower
based on their predictions.
If a major stock within a sector experiences negative or positive news, it can
charge an entire sector. Figure 1 shows
Intel (INTC) gapping down after negative news on inventories. The entire
Philadelphia semi-conductor index
(SOX) became charged and volatile

21

28

Sept.

11

18

25

2
Oct.

16

23

100,000,000
74,009,300
0

30
Nov.

13

600.00

Source: QCharts by Quote.com

immediately after. As you can see from

the chart, Intel did not hold its levels
after the first gap and followed through
by trending lower, as did the SOX index.

Early warning signs:

Volume and volatility
The first clue that a stock is ripe for a gap
opening is an increase in volume over its
normal daily average. Often, the volume

ACTIVE TRADER March 2001 www.activetradermag.com

increase will occur before the news is

known. This is an indication that news is
leaking in the market and explains the
clich stocks tell their own story ahead
of news. Remember, the biggest trading
houses often have strong indications of
sector and stock strength/weakness
before the media. Therefore, when
increases in daily volume accompanied
by directional bias are seen in the
7

absence of news, a gap is generally not

far behind.
The best way to track volume is by
knowing the average daily volume for
the stock or sector in question, in combination with its key trading levels (support or resistance). Watching the time
and sales ticker is an excellent way to

heavy buying and selling, which result

in small price movements until one side
ultimately gains control. Once a clear
imbalance is revealed, whether bullish
or bearish, the volume tends to dry up as
market participants start to lean over to
one side of the supply/demand scale.
For example, if the bulls gain control at a

get whipsawed out of trades, taking

many losses. Certainly, you also need a
clear picture of what the broader price
action looks like before even thinking
about adding volatile, big-range stocks
to your watchlist. It is also important to
dramatically lower your size in these
trades, because the range of the price

Stocks tend to overreact and move to extreme price levels,

which sets up the possibility
of a correction in the next trading session.
monitor changing volume for short-term
intraday trades. If the ticker is moving
fast, you are seeing an increase in volume its that simple.
When this occurs, you are generally
looking at a vertical spread (VS) situation. A high VS means the price pattern
is changing rapidly, up or down, and
you will need to lead the market (i.e.,
place a limit order that is the best bid or
offer) to buy or sell as the range widens.
A slower-moving issue that has a tight
horizontal spread (HS), where the
spread between the bid and ask is tight,
say 116, will not require leading. If the
stock has a tight HS, you can easily lift
offers or hit bids or even buy bids
and sell offers during tight price
range situations.
To spot volume changes that may lead
to gaps, it is important to take a broader
view of both the volume and the market
itself. Notice the dramatic volume
increase in Intel over the course of several days, in Figure 1. However, the volume interpretation changes within each
move and the stock will move the most
on the least volume once it is in motion.
For example, when stocks are growing
weaker, panic and fear is heightened and
fewer buyers are stepping up. Therefore,
as buyers disappear from the market,
stocks fall harder on light volume and
with a wider range before new support
levels are found. Once the stock establishes support levels, the volume builds
dramatically as buyers remain strong,
while sellers are still in the market. It is
at these levels that the true battle
between bulls and bears takes place.
These campaigns are evidenced by
8

key support level, buyers will exceed

sellers and the stock will trade higher on
less volume as the buyers lift thin offers
at each price level.
The lesson here is that volume indicates where the battles are fought
between bulls and bears, but once a
dominant bias is revealed, the stock will
move the most on lighter volume. Gaps
are the ultimate example of this: no volume exists, but extreme price change
does. Once this gapping action begins,
chaos is not far behind.

Chaos and high risk:

Are gaps worth it for you?
Chaos reaches its peak when stocks have
no real support or resistance levels in
sight. For example, if a stock is not well
supported until it trades 20 points lower,
volatility will be extreme.
These such conditions represent a
day-trading environment only. This is
not a time to take overnight positions.
Remember, volatility can also be defined
as chaos and, therefore, you can throw
your technical tools and indicators out
the window. If you want to day trade in
this climate, you must take a micro view
of the stock, taking small incremental
profits and losses vs. trying to trade the
overall trend.
Also important is that gaps often
reveal the beginning of new trends.
However, if youre a longer-term position trader in these situations, you must
have a much higher risk tolerance
because these price fluctuations are part
of the equation. Otherwise, you will constantly employ discipline at the wrong
time (placing stops too close, etc.) and

swings offsets the trade size needed to

profit.
Seeing the broader view of the market
is like a hurricane: When youre in it, it is
chaos, but if you can get far enough
away, you can see the larger pattern and
direction. When you trade chaotic
stocks, you must trade them accordingly
or avoid them altogether.
To determine if a chaotic market climate in general, and the overnight-gap
trade in particular, is for you, ask yourself the following questions:
1. Do I have the account size required
to take the necessary risk?
2. Do I have the temperament and
the required level of risk tolerance?
3. Am I in the money and willing
to take on additional risk for
additional reward?
4. Do I have clarity and confidence
enough to see the gap coming?
5. Did I day trade this stock the entire
day prior to the anticipated gap?
If you answered no to any of these
questions, dont even think about taking
the trade. If you answered yes to all of
the questions, then you have the criteria
to attempt it. Heres how to do it.

Taking the trade

Lets begin with the fact that, because of
volatile price pattern movements during
the day, stocks will tend to overreact or
overtrade, moving to extreme price levels that are extreme. This sets up a possible correction for the next trading session, when market makers will often gap
the stock price to levels that are advantageous for them.
The first gap that sets the stock in

www.activetradermag.com March 2001 ACTIVE TRADER

FIGURE 2 EARNINGS DISAPPOINTMENT

Leading up to the earnings release on Oct. 27, shares of American Power Conversion (APCC) traded from 18 to 22 in
five days. The earnings didnt live up to expectations and the stock gapped nearly seven points lower the following day.
American Power Conversion (APCC), 10-minute
22
21
20
19
18
17
16
15
14
13 116
Volume

1,000,000
500,000
255,300

11 12 13 14 15

0
10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11
10/20 Friday
10/23 Monday
10/24 Tuesday
10/25 Wednesday
10/26 Thursday
10/27 Friday
10/30 Monday

Source: QCharts by Quote.com

motion because of unforeseeable news is

generally not predictable. However, the
gaps that may follow can occur for some
of the following reasons:
Additional news, such as earnings
releases.
Short squeezes and profit taking
(hook closes).
S&P 500 futures volatility.
These different factors can provide
various signals that offer opportunities
for gap trades.
Earnings. Earnings are perhaps the
most significant factor regarding gap
trades, because they have such a substantial impact on both stocks and sectors.
The market is far more unforgiving of
missed earnings than it is rewarding to
earnings that meet estimates. Many companies meet expectations and still get
hammered the day after their announce-

ments. This is because most positive earnings expectations are built into the stock
price in the days prior to the report. For
this reason, stocks have a greater propensity to fall when companies merely meet
expectations.
When expectations are missed, the
downside bias is dramatic. Therefore,
you should rarely take an overnight
position in a company that is reporting
earnings after the close. If you do, your
natural bias should be to trade the short
side especially in this market environment, where good earnings are often no
match for inflationary pressure, rising
interest rates and oil prices.
Because so many stocks have an
upside bias in the days prior to an earnings report, it is best to sell into the news
if youre long the stock, and wait for the
outcome. Figure 2 is an example of what
companies experience when they miss

ACTIVE TRADER March 2001 www.activetradermag.com

expectations.
Short squeezes and profit taking.
Short squeezes and profit taking are the
most common reasons stocks will tend to
build above-average volume into the
close and cause what is called a hook
close.
In a short squeeze, a stock is in a
downtrend and market makers suspect
there may be many short sellers in the
market. The squeeze and the hook occur
when the professionals begin to buy the
stock rapidly into the close, causing price
to rise swiftly and forcing the short sellers to cover in a panic. Profit taking generally occurs when a stock is in a rising
trend but shows a weak close accompanied by high volume. At this point,
traders with long positions begin to sell
the stock to take a profit. Figure 3 shows
an example of a short squeeze, while
Figure 4 is an example of a hook formed
9

FIGURE 3 SHORT SQUEEZE

On Oct. 26, Amgen (AMGN) closed the day near its high on a sudden spurt of buying that was likely the result of a short
squeeze. A look at the intraday chart reveals the stock was in a downtrend, with the previous support level at 69 12
becoming resistance.
Amgen (AMGN), 5-minute

72

70

68

66

64

62

60
59 18
1,200,000
1,057,900
1,000,000

Volume

800,000
600,000
400,000
200,000
12

13

14

15

10
11
10/25 Wednesday

12

13

14

15

10
11
10/26 Thursday

12

13

14

15

0
10
10/27 Friday

Source: QCharts by Quote.com

during profit taking.

If youre not in a profitable situation
from day trading the stock, you should
not take the overnight gap trade. It is
best to stand aside and trade the open
the following day, after the stock gaps
open if it does. If you had a profitable
day-trading session, you can take the
overnight position if you think the riskreward relationship is satisfactory.
Remember, when going after an
overnight position, it must always be
with purpose and confidence. Never

hold a losing position overnight, hoping

the stock will come back. That is nothing but gambling.
S&P 500 futures. S&P 500 futures are
an important consideration when taking
an overnight gap trade. You should look
at the correlation between the futures
market and the index in relation to the
gap-trading plan you have in mind. If
the futures are moving decisively higher
going into the close, and you have other
independent reasons for the stock in
question to gap higher the next day, and

The first gap that sets the stock

in motion because of unforeseeable news
is generally not predictable.
10

all other questions and factors can be

answered favorably, you could keep
your long position overnight.
The point is you must have clarity and
confirmation on all levels when taking a
position overnight. Still, the most significant piece of information comes from
the stock itself and how it behaved while
you where trading and watching it in the
days prior to the anticipated gap.
Without this information, you will not
be able to make a decision whether to
take a gap trade or not.
Gap trading is a risky business, and
the professionals who quote stocks up or
down prior to the open have a vested
interest in doing so. If you were a market
maker who made your living buying and
selling stocks from the public while providing liquidity to the market, where
would you open a stock with poor news
knowing you were to receive market on

www.activetradermag.com March 2001 ACTIVE TRADER

FIGURE 4 PROFIT-TAKING
Transwitch Corp. (TXCC) was on its way to recovery from a sell-off in the fiber optic group. Along the way, profit taking
on Oct. 30 forced the price lower at the end of the day. The next morning the stock gapped higher, with the buyers
once again firmly in control.
Transwitch Corp. (TXCC), 5-minute

56 516
56
54
52
50
48
46
44
42

Volume

200,000
150,000
100,000
50,000
8,200

14

15

10

11

12
13
10/27 Friday

14

15

10

11
12
10/30 Monday

13

14

15

10

11
12
10/31 Tuesday

Source: QCharts by Quote.com

open orders? You would open it as low as

possible, where you felt the stock was
well supported. This is known (from the
market makers perspective) as buying
weakness.
Conversely, with strong news, knowing you would be selling at the open,
where would you open the stock? The
higher the better, so that you could short

stock to buyers at what would be a significant resistance level. This is referred

to as selling strength.
This is why gaps have a greater propensity to close immediately after the
open: After the initial panic selling or
mania buying has been gobbled up by the
market maker or specialist, a vacuum
often develops and the stock will reverse.

By contrast, if the stock continues to follow-through in the direction of the gap, its
a strong indication that the trend will continue.
Remember, however, that while these
rules are good to use as a guide, they
should not be traded with indiscretion.
There are many factors that impact any
individual gap-trading situation.

The market is far more unforgiving of missed earnings

than it is rewarding to earnings that meet estimates.
You should rarely take an overnight position in a company
that is reporting earnings after the close. If you do,
your natural bias should be to trade the short side.
ACTIVE TRADER March 2001 www.activetradermag.com

11

&

FUTURES

Trading Strategies

OPTIONS

Trading the

OPENING GAP

Watching pre-market volume is a good way to determine whether

to trade or fade the opening move.

BY JOHN CARTER

pening price gaps the

distance between the regular-session opening price
and the previous days
closing price are stomach-churning
events when the market makes a big
move against you, but they represent
low-risk trade opportunities if you know
which gaps are likely to be followed by
predictable patterns.
In terms of the price behavior that follows opening gaps, not all markets are
created equal. Gaps in individual stocks
and commodities do not act the same as
TABLE 1 FILLING THE OPENING
GAP: RAW DATA
Between Jan. 15, 2002, through
February 2004 (528 occurrences),
an average of 76 percent of all
opening gaps closed at some point
during the same day. This is the
breakdown by day of week. Adding
the pre-market volume filter
increased the percentages.
Day

Percentage of
gaps filled

The best markets for gap plays

The S&P 500 and the Dow are the best
markets to trade the opening gap

because of the diversity of their component stocks. Both indices represent collections of stocks from different industries
that are more likely to react independently to news events. In the technologyheavy Nasdaq, opening price gaps can
take longer to fill because the majority of
the stocks will react similarly to news.
The key to trading opening gaps is
being able to predict the likelihood a
particular gap will be filled. Dissecting
the market conditions that produce a
gap is as important as analyzing a gap
itself. For example, an opening gap following high pre-market cash trading
volume can take weeks to get filled
because high volume increases the odds
the market will continue to move in the
direction of the gap.
Some of the biggest gaps are caused
by major news events, such as the outbreak of a war, but gaps caused by minor
news items are much more common.
Generally, such gaps are smaller, fill
quickly (see Table 1) and can be faded
(the act of trading against the direction
of the gap) more effectively. Lets look at

TABLE 2 TRADE MANAGEMENT GUIDELINES

The higher the volume, the greater the likelihood the market will continue
in the direction of the opening gap. As a result, no trade is taken when vol ume is above 70,000.

Monday

65%

Pre-market volume
in key stocks

Tuesday

77%

Less than 30,000

Full size

Exit entire position at gap fill

Wednesday

79%
82%

Between
30,000 and 70,000

2/3 size

Thursday

Exit half at 50 percent of gap

fill, half at gap fill

Friday

78%

Above 70,000

Source: Tradethemarkets.com
12

those in multi-item instruments such

as stock indices because a news item will
control the entire market instead of just a
portion of it. Earnings announcements,
corporate scandals and other companyspecific events can create gaps in a component stocks chart that never get filled.
Because of the unpredictable nature of
various events that can impact the price
of an individual stock, they make poor
candidates for the opening-gap trade.
In contrast, stock index futures such as
the E-mini S&P (ES) or the mini-sized
Dow (YM) are better candidates for
opening-gap plays because they consist
of multiple components that respond differently to news. For example, although a
stock index futures contract may gap up
on a news item, there will be individual
stocks within the index that will either
ignore the news or sell off. This weighs
the index down and creates a trade
opportunity as the market fills the gap.

Position size

No fade trade

Trade target

No fade trade

Source: Tradethemarkets.com
www.activetradermag.com December 2004 ACTIVE TRADER

the specific criteria for identifying those

gaps with the best chances of reversing.

The pre-market volume indicator

The most important indicator for determining which opening gaps can be
faded is the pre-market volume in a specific set of stocks.
Check the pre-market volume at 9:20
a.m. ET (10 minutes before the regular
cash session opens) in the following
stocks: KLA-Tencor Corporation (KLAC),
Maxim Integrated Products, Inc. (MXIM),
Novellus Systems, Inc. (NVLS) and
Applied Materials, Inc. (AMAT). These
representative stocks were selected
through a trial-and-error process.
If the market is really set up to move,
there will be significant volume in the
cash market in pre-market trading. If the
market is setting up for a head fake (a
move in one direction that is quickly
reversed), pre-market volume will be
low, which reflects a lack of conviction in
the move. This is the preferred setting
for an opening-gap trade.
If the pre-market stocks have each
traded less than 30,000 shares at this
time, analysis of the prior 500 trading
days shows the opening gap, up or
down, had an 80-percent chance of filling the same day. However, if the volume for each stock is between 30,000
and 70,000, the gap only has about a 60percent chance of filling that day, while
the midpoint of the gap has an 85-percent chance of being hit.
Finally, if the pre-market volume for
each stock is above 70,000, the chances of
the gap filling that day drop to 30 percent. In these cases, you should ignore
the news and follow the direction of the
gap. Table 2 provides guidelines for
using volume information to manage
trades. As the volume increases, the
position size shrinks and the profit-taking becomes more conservative.
If one stock has volume above 70,000
but the others are below the threshold,
check to see if the news pertains to this
company alone. If it does, ignore it. If the
news is not specific to the company,
trade the more conservative position.

The strategy
Figure 1 is a five-minute chart of the

If the market is poised to move, there

will be significant pre-market volume
in certain stocks.
mini Dow futures. You can use any time
interval a one-minute, five-minute or
15-minute chart, etc. as long as you
can view the opening. This means the
chart must be set up to reflect the opening and closing of the regular trading
session, 9:30 a.m. to 4 p.m. ET (4:15 p.m.
for stock index futures prices). Many
traders are used to watching a separate
chart of the continuous 24-hour futures
session, but of course, opening gaps

the Dow gapped up 47 points as a result

of a positive earnings report from Intel
(INTC). On this day, pre-market volume
was below 30,000.
As a result, the appropriate trade is to
immediately short the gap on the open
using a full position size, as indicated in
Table 2. To keep things simple, well use
nine contracts as a full position, which
makes a two-thirds position six contracts
and a one-third position three contracts.

FIGURE 1 THE OPENING GAP

This 47-point-plus opening gap in the mini Dow futures was filled in the first
hour of trading for a $235 per-contract profit.
9,830

Mini Dow futures (YM), five minute

9,820
Gap is filled for a 47-point
gain, or $235 per contract
(47 points x $5 per point).

9,810
9,800
9,790
9,780
9,770
9,760
9,750
9,740
9,730
9,720
9,710
10/15/03

11:00

12:00

13:00

14:00

15:00

9:00

9,700

10:00

Source: eSignal

wont show up.

Figure 1 shows the first day in a set of
back-to-back earnings announcements
that caused opposite reactions in the
market. On the morning of Oct. 15, 2003,

ACTIVE TRADER December 2004 www.activetradermag.com

We will use a $100,000 account, which

means we are trading one contract for
each $11,100 in the account for a full position. Although you can trade a mini Dow
or E-mini S&P contract with only a few
13

&

FUTURES

OPTIONS

Trading Strategies continued

FIGURE 2 THE DAY AFTER

One day after the trade setup shown in Figure 1, the mini Dow contract
opened lower, setting up a long trade.
9,800

Mini Dow futures (YM), five minute

9,790
Gap filled for a 61-point
gain, or $305 per contract.

9,780
9,770
9,760
9,750
9,740
9,730
9,720
9,710
9,700

10/16/03
15:00
9:00 10:00
Source: eSignal

11:00

12:00

13:00

14:00

FIGURE 3 EMOTIONS TRIGGER GAP

The E-mini S&P futures made a downside opening gap on Aug. 2, 2004, on terrorist
threats. The market spent most of the day filling the gap.
E-mini S&P 500 continuous contract (ES), five minute

1,106
1,105

Close on 7/30/04:
1,103.75

1,104
1,103
1,102
1,101
1,100
1,099
1,098
1,097

Open on 8/2/04:
1,097.00
14:45 15:0515:25 15:45

Source: TradeStation

14

8/2

1,096

10:00 10:2010:4011:00 11:20 11:4012:00 12:20 12:40 13:00 13:2013:40

thousand dollars, this trading plan controls risk by limiting exposure relative
to the amount of available capital.
Use a 1:1.5 reward/risk ratio (risking
1.5 points to make 1 point) for gap
trades that are less than 40 mini Dow
points or 4 E-mini S&P points. For gaps
larger than these, use a 1:1 reward/risk
ratio. In the case of Figure 1, we would
risk 47 points to make 47 points. If the
gap had been 30 points, we would risk
45 points.
Some traders might question an
approach that risks more than the
potential profit. Most beginning traders
are taught to use a 3:1 reward/risk
ratio, risking 1 point to gain 3. They
inevitably wonder why they are repeatedly stopped out just before the market
turns. In general, wider stops produce
more winning trades; the key is to trade
only those setups with a better than 80percent chance of winning.
The market sold off immediately
after the bell, filling the opening gap
within an hour. Ironically, the next day
IBM came out with a disappointing
earnings report, knocking the market
down on the open. Figure 2 shows the
resulting buy setup had just a small
open loss at one point, although many
traders might have been stopped out
on the pullback around 11 a.m. ET.
However, keep in mind the strategy
is to maintain a reward/risk ratio of
1:1, not to tighten your stop when
the market moves in your favor. If
the stop had been hit, the loss would
have been approximately $305 per
contract ($2,745 for the nine-contract
full position), not including slippage
and commissions. This loss is reasonable because of the 80-percent
success rate of the setup.
Using a tighter initial stop or trailing stop would have turned this
position into a losing trade or, at
best, a breakeven trade. Using the
risk parameters designed for this
trade setup allowed the position to
remain open until the gap was filled
for a gain of 61 points. As a rule,
using a trailing stop will negatively
affect the gap trades win/loss ratio.
When the trade is executed, the
best thing a trader can do is to walk
away and let the orders do their
work. This is the difference between
professionals
and
amateurs:
Professionals wont second-guess a

www.activetradermag.com December 2004 ACTIVE TRADER

trading methodology, while amateurs are constantly adjusting.

Ignore the reasons for the gap

The size or cause of a gap has little
impact on whether or not it will be
filled. Figure 3 shows an example
of emotions triggering an opening
price gap when, on Aug. 2, the
market gapped down on the open
because the U.S. government
issued a terror warning the previous day. There were rumors of a
plan to blow up a large financial
institution.
However, after a choppy first
half of the day, the market firmed,
shorts got nervous and started covering, and the gap was filled by
1:30 p.m. ET for a 6.75-point S&P Emini profit ($337.50 per contract).

FIGURE 4 MULTIPLE GAPS

The first opening gap on this chart which remained unfilled for the next six days
set up a short trade that was stopped out for a loss. Subsequent opening gap trades
were more successful.
Mini Dow September futures (YMU04), 15 minute
Gap of +62 points
fills in 6 bars

Gap of -52 points

fills in 9 bars

Short break of bear

flag. Target is gap
from 8/18

Gap of +13 points

fills in 1 bar

9,500
9,480
9,460
9,440
9,420
9,400
9,380

Gap of +44 points fills in 9 bars

9,360
9,340
9,320

Relax and trade

9,300
Figure 4 shows a 15-minute chart of
Gap
on
8/18
of
+44
points
the September mini Dow futures
fills on 8/25
9,280
(YMU04) with an opening gap on
Aug. 18 that did not get filled for
8/18
13:15 8/19 11:45 14:15 8/20 12:45
8/21
13:45 8/22 12:15
8/25
13:15 8/26
six trading days. (Other opening
gaps occurred before price eventuSource: TradeStation
ally filled the first gap.) On this day,
the mini Dow gapped up a modest
profit ($2,295). All these gaps followed each type of trade setup.
44 points prior to the release of some light pre-market volume, so they were
Gaps are the one moment of the tradeconomic numbers. The pre-market volexecuted with full positions.
ing day where everyone has to show
ume was modest, between 30,000 and
On Aug. 22, 2003, Intel announced their poker hand, and this creates a big
70,000 shares for the key stocks, so the
cautious upside earnings revisions.
advantage for short-term traders.
appropriate step was to short a two- The market exploded to the upside and
Understanding the dynamics behind
thirds-size position on the open.
gapped right above key resistance. The
opening gaps is paramount to trading
The market rallied, sold off a little just trade was to short the 62-point gap with them successfully.
prior to the economic numbers, and then a full-size position. Six bars later, the tarshot higher once the numbers were
get was hit for a 62-point profit, or $310 For information on the author see p. 10.
released. Using the 1:1 reward/risk ratio per contract ($2,790).
resulted in a 44-point stop. The market
During the afternoon session, the marRelated Active Trader
never retraced to the gaps midpoint ket traced out a bear flag pattern. With
level (where half the position could be the opening gap under the market still
articles
covered), and instead rallied right
unfilled, the trade was to place a sell stop
Trading the overnight gap by David
through the stop, producing a loss of at 9,392 to let the trend of the market iniNassar, March 2001, p. 66
$220 per contract. For a two-thirds positiate the trade based on a breakdown of
Morning reversal strategy by Bryan
tion (six contracts) the loss was $1,320.
the flag. The entry stop was filled and the
C. Babcook and Arthur Agnelli,
This move left an open gap below the risk point for the trade was above intraMay 2003, p. 36
market. The next day the market opened day resistance at 9,455. The target was the
modestly lower, triggering a long trade Aug. 18 gap at 9,304. The market spent
Technical Tool Insight: Gaps, April
that resulted in a quick $65-per-contract the rest of the day trending lower, filling
2003, p. 82
profit ($585 total). The following day the
the gap and resulting in an 88-point gain,
Technical Tool Insight: Islands,
market opened 52 points lower and or $440 per contract ($3,960).
August 2002, p. 82
filled the gap a few hours later for a
$260-per-contract profit ($2,340). The
A brief window of opportunity
You can purchase past articles online
next day, the market gapped up 44 The markets nature is to prevent as
at www.activetradermag.com/
points, triggering a short trade that came many people as possible from consispurchase_articles.htm and download
close to the stop-loss point, but eventual- tently making money, which is why it is
them to your computer.
ly filled the gap for a $255-per-contract
crucial for a trader to follow rules for
ACTIVE TRADER December 2004 www.activetradermag.com

15

FIGURE 1 EQUITY CURVE

The frequency of down gaps increased after the broad market topped out in early
2000. The system exposure (light green area) increased substantially after this
point. Note that many of these gaps are still open.

Gap closer

130,000
120,000

Markets: Any.

110,000
100,000

System concept: Most traders are familiar

90,000
with the technical analysis axiom, All gaps
are eventually closed. A gap occurs when a
80,000
price bars high is lower than the previous low
70,000
or its low is higher than the previous high. A
60,000
significant gap creates a void in which no
trades occur, as shown in Figure 1. An open50,000
ing gap occurs when price opens above the
40,000
previous high or below the previous low; such
3
0,000
gaps can be filled the same bar, in which case
no visible bar-to-bar gap (such as the one in
20,000
Figure 1) will appear on the chart.
10,000
The idea that gaps are eventually closed
stems from the absence of trades within the
0
3/3/93
range of the gap. Because there are no traders
who are holding positions within the gap zone
(some may have entered positions earlier in
the charts history), there is an absence of the
upside resistance that is typically caused by traders seeking to
exit at breakeven or a profit-target level. Because of this lack of

1/7/94

1/3/95

1/2/96
Equity

1/2/97

1/4/99
Cash

1/3/00

1/2/01

1/2/02

1/2/03

Linear reg

resistance, price often moves sharply to close the gap when it

first recovers and penetrates the gap zone. This type of price
movement can also lead to the island
FIGURE 2 SAMPLE TRADES
reversal pattern, which occurs when a
gap in one direction is followed by (after
The system went long when Apple Computer gapped down more than 13 percent on
one or more intervening bars) a gap in the
June 19, 2002. Price started moving in the direction of closing the gap, but another
opposite
direction.
down gap occurred on July 17, 2002, causing a new long position to be established.
This test is designed to see if the axiom
Apple Computer (AAPL), daily
regarding closing gaps holds water. The
25.00
10 gaps, seven closed (70%)
system tested here goes long the day after
a large gap down and holds the position
24.00
until price reaches the low of the bar
23.00
immediately before the gap i.e., when
the gap is closed.
22.00
This system is for experimental pur21.00
poses only. The goal is to test the effectiveness of trading gaps in the simplest way
20.00
possible; no protective stops are included.
19.00
Because of this, positions can be held
indefinitely and result in substantial draw18.00
downs when gaps are never closed. If you
wanted to actually trade a gap-based sys17.00
tem, you would most likely use a protec16.00
tive stop to protect against these losses.
Buy
15.00
14.00
Buy

Volume

20M

July 2002
Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)

16

August 2002

September 2002

Rules:
1. Enter long on the open the day after a
down gap greater than the 20-bar average true range (ATR) is completed.
2. Place a limit order to sell the position at
the low price of the bar that immediately preceded the gap.
3. The system will maintain multiple

www.activetradermag.com May 2003 ACTIVE TRADER

FIGURE 3 DRAWDOWN CURVE

open long positions (see Figure 2).
4. Hold the position indefinitely until the gap is
closed and the limit sell is triggered.
Money management: Risk 9 percent of account
equity per trade. This level was chosen because
it was the largest position size that allowed all
gaps to be traded during our test period.
Starting equity: $100,000 ($10 slippage/commission deducted per trade).

0%
-2%
-4%
-6%
-8%
-10%
-12%
-14%
-16%
-18%
-20%
-22%
-24%

As more gaps were opened and more long positions established,

a large drawdown began in 2000.

Test data: The system was tested on the Active

Trader Standard Stock Portfolio, which contains
3/3/93
1/28/94
the following 18 stocks: Apple Computer
(AAPL), Boeing (BA), Citibank (C), Caterpillar
(CAT), Cisco (CSCO), Disney (DIS), General Motors (GM),
Hewlett Packard (HPQ), International Business Machines
(IBM), Intel (INTC), International Paper (IP), JPMorgan Chase
(JPM), Coke (KO), Microsoft (MSFT), Sears (S), Starbucks
(SBUX), AT&T (T) and Wal-Mart (WMT).
Test period: January 1993 through January 2003.
System results: A total of 62 gaps occurred during the 10-year
test period. Of these, 50 (80 percent) were closed for a profit.
The remaining 12 gaps were open at the end of the test period.
The average profit for the closed gaps (which took, on averSTRATEGY SUMMARY
Profitability
Net profit ($):
Net profit (%):
Exposure (%):
Profit factor:
Payoff ratio:
Recovery factor:

11,942
11.94
28.42
1.27
0.34
0.35

Drawdown
Max. DD (%):
Longest flat days:

-24.75
465

2/1/95

1/30/96

2/3/97

1/4/99

1/3/00

1/2/01

1/2/02

1/2/03

age, 100 trading days to close) was just under 11 percent. By

comparison, the average loss of the 12 gaps that are still open
is a sharp -32 percent, and the average number of trading days
they have been open is about 350 (about one and a half years).
That most of the gaps in the test portfolio within the past 10
years have been closed reinforces the idea that gaps do have a
tendency to get filled although it often takes a while.
However, the damage done by the minority of gaps that did
not close wiped out most of the profits achieved from the
majority of gaps that did close. This leads to the conclusion
that trading gaps on their own entails significant risk.
However, it is possible to combine gaps with other trading
tools and methods. The old saying, All gaps are eventually
closed, may not be totally accurate, but knowing the odds are
good that a certain price target will be reached can play an
important role in a trading strategy.

Trade statistics
No. trades:
62
Win/loss (%):
80.65
Avg. gain/loss (%):
2.69
Avg. holding time:
148.15
Avg. profit (winners):
10.97
Avg. hold time (winners): 100.06

PERIODIC RETURNS

Avg. loss (losers) %:

-31.80

Weekly

0.03%

0.16

6.56% -12.50%

49.23%

17

Avg. hold time (losers):

Max. consec. win/loss:

348.50
38/4

Monthly

0.15%

0.16

13.54% -9.68%

47.90%

Quarterly 0.43%

0.15

16.34% -14.11%

53.66%

Annually

0.22

10.73% -12.90%

60.00%

LEGEND: Net profit profit at end of test period, less commission

Exposure the area of the equity curve exposed to long or short positions, as
opposed to cash Profit factor gross profit divided by gross loss Payoff
ratio average profit of winning trades divided by average loss of losing
trades Recovery factor net profit divided by max. drawdown Max DD
(%) largest percentage decline in equity Longest flat days longest
period, in days, the system is between two equity highs No. trades num ber of trades generated by the system Win/Loss (%) the percentage of
trades that were profitable Avg. profit the average profit for all trades
Avg. hold time the average holding period for all trades Avg. profit
(winners) the average profit for winning trades Avg. hold time (winners) the average holding time for winning trades Avg. loss (losers)
the average loss for losing trades Avg. hold time (losers) the average
holding time for losing trades Max. consec. win/loss the maximum
number of consecutive winning and losing trades

Compiled by Dion Kurczek of Wealth-Lab Inc.

Avg. Sharpe Best Worst

return ratio return return

1.60%

%
Max.
Max.
Profitable consec.
consec.
periods profitable unprofitable

LEGEND: Avg. return the average percentage for the period Sharpe ratio
average return divided by standard deviation of returns (annualized)
Best return best return for the period Worst return worst return for
the period % Profitable periods the percentage of periods that were prof itable Max. consec. profitable the largest number of consecutive prof itable periods Max. consec. unprofitable the largest number of consec utive unprofitable periods
Trading System Lab strategies are tested on a portfolio basis (unless
otherwise noted) using Wealth-Lab Inc.s testing platform.
If you have a system youd like to see tested, please send the trading and money-management rules to editorial@activetradermag.com.

Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or
promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not
guarantee future results; historical testing may not reflect a systems behavior in real-time trading.

ACTIVE TRADER May 2003 www.activetradermag.com

17

FUTURES

Trading System Lab

FIGURE 1 PORTFOLIO EQUITY CURVE

Gap closer

The equity curve exhibits some volatility, but also an overall upward
bias and extremely low market exposure. This is a result of the small
number of trades, as well as their short holding periods.

Markets: Any.

System concept: The stock Trading System Lab (p. 54) featured an experimental system designed to trade gaps. The
intention was to go long on every down gap and hold the
position until the gap was closed (if it ever closed). This provides useful information about the dynamics of gap behavior.
However, it is not possible to hold a losing futures position in a similar manner because the higher leverage in
futures results in losses of a much larger magnitude. Taking
this into account, the futures system goes long right when
price is starting to fill a down gap. The absence of resistance
in the price void of the gap should provide positive momentum for a long trade. Based on the results of the stock test, it
is likely most of the gaps will be filled.
In addition, this system uses three different exits to protect capital while giving trades room to breathe. The strategy uses a breakeven stop entered soon after the trade is profitable to protect against a reversal. When the gap is not filled
and prices do not reach our breakeven level, we employ a
wide stop-loss order.
The system should have a large number of winning and
breakeven trades, and a small number of large losses.
Because of the high expected win-loss ratio, the strategy uses an
aggressive maximum risk setting (10 percent equity loss per
FIGURE 2 SAMPLE TRADES

200,000
190,000
180,000
170,000
160,000
150,000
140,000
130,000
120,000
110,000
100,000
90,000
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0

8/16/93

7/4/94

6/2/95

Equity

370.00

360.00

350.00

340.00

330.00

320.00

310.00

300.00

290.00

Volume
100,000

May 1999

June 1999

July 1999

Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)

18

August 1999

September 1999

4/1/97

3/2/98

Cash

1/3/00

1/2/01

1/2/02

Linear reg

trade). All traders must weigh these considerations and determine their personal risk tolerance when deciding on the stoploss and maximum risk levels.

Gaps in gold trigger two trades. The green lines represent the entry points and the red lines
represent the profit-target exits. Notice how prices gapped up to close the first gap down,
forming an island reversal. The second gap also closed, but not before the trade was
stopped out. Increasing the stop-loss distance would have turned this trade into a winner.
Gold futures (GC), daily

5/1/96

October 1999

Rules:
1. A long entry setup occurs when there is
a down gap greater than the 20-bar average true range (ATR). Multiple open
trades are acceptable.
2. Go long on a buy stop order at the high
of the down-gap bar plus one tick.
3. Exit with a profit using a limit order at
the low of the bar that preceded the
down gap.
4. Place a stop-loss order below the entry
price that is three times the distance
between the entry price and the profit
target level.
Note: Wait until the close of the entry bar
before placing the profit target and stoploss orders.
5. As soon as the contract closes with a gain
of at least one percent, place a breakeven
stop to exit at the entry price.
Risk control and money management:
1. Starting equity: $100,000. Deduct $10
slippage/commission per contract
(entry and exit).
2. The number of contracts to buy is determined by calculating the distance
between the entry price and the initial
stop-loss level. Buy the number of
contracts that results in a maximum loss
of 10 percent if the stop-loss is hit.

www.activetradermag.com May 2003 ACTIVE TRADER

FIGURE 3 DRAWDOWN CURVE

Test data: The system was tested on the Active Trader
Standard Futures Portfolio, which contains the following 20 futures: DAX30 (AX), corn (C), crude oil (CL),
German bund (DT), Eurodollar (ED), Euro Forex (FX),
gold (GC), copper (HG), Japanese yen (JY), coffee (KC),
live cattle (LC), lean hogs (LH), Nasdaq 100 (ND), natural gas (NG), soybeans (S), sugar (SB), silver (SI), S&P
500 (SP) and10 year T-Notes (TY).
Test period: This test used ratio-adjusted data (from
Pinnacle Data Corp.) spanning August 1993 to
November 2002.

0.00%
-2.00%
-4.00%
-6.00%
-8.00%
-10.00%
-12.00%
-14.00%
-16.00%
-18.00%
-20.00%
-22.00%
-24.00%

Test results: There were a total of 69 trades during the

test period. This was less than the number of gaps that
occurred, but because the system enters as price begins
to penetrate the gap, there could be setups that have not triggered trades yet. Eleven of the trades triggered our breakeven
stop and were closed at the breakeven level. Ten trades were
losers, while 48 were winners. This confirms our expectation of
the systems win-loss behavior.
Counting breakeven trades as losers, the system had a winloss ratio of nearly 70 percent. The average profit of winning

8/16/93

STRATEGY SUMMARY
Profitability

Trade statistics

Net profit ($):

94,659

Net profit (%):

94.66

Exposure (%):

3.07

No. trades:
Win/loss (%):

69
69.57

Avg. gain/loss (%):

0.96
16.62

Profit factor:

1.79

Avg. holding time:

Payoff ratio:

0.96

Avg. gain (winners) %:

2.54

Recovery factor:

2.08

Avg. hold time (winners):

8.96

Avg. loss (losers) %:

Drawdown
Max. DD (%):
Longest flat days:

-2.65%

-25.27

Avg. hold time (losers):

34.14

570

Max. consec. win/loss:

7/3

The largest drawdown, which began in late 1999, was eliminated in

mid-2002. The system exhibits a favorable recovery factor (the net
profit divided by the maximum drawdown) of 2.08.

LEGEND: Net profit profit at end of test period, less commission

Exposure the area of the equity curve exposed to long or short positions, as
opposed to cash Profit factor gross profit divided by gross loss Payoff
ratio average profit of winning trades divided by average loss of losing
trades Recovery factor net profit divided by max. drawdown Max DD
(%) largest percentage decline in equity Longest flat days longest
period, in days, the system is between two equity highs No. trades num ber of trades generated by the system Win/Loss (%) the percentage of
trades that were profitable Avg. gain the average profit for all trades
Avg. hold time the average holding period for all trades Avg. gain
(winners) the average profit for winning trades Avg. hold time (winners) the average holding time for winning trades Avg. loss (losers)
the average loss for losing trades Avg. hold time (losers) the average
holding time for losing trades Max. consec. win/loss the maximum
number of consecutive winning and losing trades

7/5/94

6/6/95

5/3/96

4/4/97

3/5/98

1/3/00

1/2/01

1/2/02

trades was 2.54 percent, while the average loss of losing trades
was -2.65 percent. Overall, these are very positive statistics,
considering the degree to which the win-loss ratio is leaning
toward the win column.
The similar behavior of gaps in stocks and futures is interesting. By analyzing the behavior of gaps in one market we
were able to design a profitable system based on the same phenomenon in a different market.
The message of this strategy is that it is worthwhile to pay
attention to gaps, especially when prices start to fill a gap. The
lack of resistance in the gap area can be exploited if you can act
quickly enough.
Compiled by Dion Kurczek and Volker Knapp of Wealth-Lab Inc.

PERIODIC RETURNS
Avg. Sharpe Best Worst
return ratio return return

%
Max.
Max.
Profitable consec.
consec.
periods profitable unprofitable

Weekly

0.16%

0.50

15.91% -12.98%

24.28%

55

Monthly

0.70%

0.52

19.31% -12.98%

36.28%

13

Quarterly 2.05%

0.52

32.62% -12.16%

52.63%

Annually 10.21% 0.55

39.42% -12.75%

77.78%

LEGEND: Avg. return the average percentage for the period Sharpe
ratio average return divided by standard deviation of returns (annualized)
Best return best return for the period Worst return worst return
for the period % Profitable periods the percentage of periods that were
profitable Max. consec. profitable the largest number of consecutive
profitable periods Max. consec. unprofitable the largest number of
consecutive unprofitable periods
Trading System Lab strategies are tested on a portfolio basis (unless
otherwise noted) using Wealth-Lab Inc.s testing platform.
If you have a system youd like to see tested, please send the trading and money-management rules to editorial@activetradermag.com.

Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or
promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not
guarantee future results; historical testing may not reflect a systems behavior in real-time trading.

ACTIVE TRADER May 2003 www.activetradermag.com

19