Building a GAP Trading Strategy

[brownsfan019 17]

There was a brief mention of gaps in another thread and I thought I'd throw this one out there and see where it might go. Personally, I've always been interested in trading the gaps, but never developed it into something that I could make regular money at.

 

First, a gap according to investopedia is:

A break between prices on a chart that occurs when the price of a stock makes a sharp move up or down with no trading occurring in between. Gaps can be created by factors such as regular buying or selling pressure, earnings announcements, a change in an analyst's outlook or any other type of news release.

 

In stocks, you see gaps all the time. In futures, you can easily see gaps as well if you set your chart to RTH only (regular trading hours). If you set your chart to 24 hours, you will rarely see anything resembling a gap.

 

Second, why discuss gaps? There is a theory or idea in trading that says sooner or later, all gaps get 'filled'. Filled means that price will eventually travel the distance where price gapped overnight to 'fill' it in.

 

The assumption being made on gap plays is this then - if we believe that gaps will fill, is there a viable daytrading strategy there?

 

Here's my personal take on it - some days, you can just buy/sell the first candle pattern you see that would move the price in the direction of filling the gap - other days, not so much. For example, price gaps down, you buy the first hammer you see and set your profit target where the gap would fill.

 

Example from ES 5 Min Chart:

 

 

 

End result: 1 trade for +8.75. Not too shabby, right?

 

 

But then you catch a day like this:

 

 

 

 

 

In summary, there are days where this gap play is very simple and clean. Other days (such as today, May 21) it can get ugly if you keep buying. Basically, if you get caught into a trend day that is the opposite of the way you are buying/selling, hold on for dear life.

 

With that said, maybe this could work if you give it a limited number of 'bullets' - ie, how many times you are willing to try to pick off the gap. I refer to bullets b/c that term is used a lot in poker when you are bluffing - how many bullets are you willing to fire to bluff? Same idea here - how many bullets are you willing to fire to basically sell the HOD or buy the LOD and ride it to the gap fill.

 

Example of firing 2 bullets:

 

 

==============

 

There could be a tradable strategy if you can keep your losses to a minimum. Exactly what that means, I'm not sure. Maybe w/ some discussion here it could help anyone using gaps in their planning.

 

DO YOUR OWN WORK AND RESEARCH BEFORE PUTTING ANY REAL MONEY AT RISK.

THE IDEA PRESENTED HERE IS INTENDED FOR DISCUSSION PURPOSES AND NOT MEANT TO LAY OUT A TRADING PLAN.

I PERSONALLY HAVE NEVER USED THIS TO TRADE LIVE MONEY ON.

 

 

Note: for entries, I assumed entry would be using a buy stop or sell stop to help minimize the amount of losing trades.

Edited May 21, 2009 by brownsfan019

[Tinson 10]

Very nice presentation and commentary. Have you done historical back testing with consistency good results? If so what are the perfomance P/L ratios?

Lately,we have gap open almost every day.

 

Thanks,

Tinson

[brownsfan019 17]

As my post said:

 

Personally, I've always been interested in trading the gaps, but never developed it into something that I could make regular money at.

 

In other words, I have never used this to trade. The reason for the post was to spark conversation and see if anyone using gaps would like to give some ideas.

[Tinson 10]

Thanks for clarification. Gap does not mean much these days for there are too many action traders. I don't bother to filter the gap in other trading strategies in any time frame.

Tinson

[BlowFish 10]

Second, why discuss gaps? There is a theory or idea in trading that says sooner or later, all gaps get 'filled'. Filled means that price will eventually travel the distance where price gapped overnight to 'fill' it in.

 

The assumption being made on gap plays is this then - if we believe that gaps will fill, is there a viable daytrading strategy there?

 

There is a big issue right there even if you accept the basic premise the issue then becomes when will the gap fill and how far will price travel against you in the meantime?

[Tams 20]

Second, why discuss gaps? There is a theory or idea in trading that says sooner or later, all gaps get 'filled'. ...

 

 

There was a study done... this was a long time ago, I do not have the reference anymore.

 

Basically it found that about 50% of the gaps were filled within the next oscillation...

some were eventually filled, e.g. 6 months later, which were of little use to a gap trader.

some were never filled.

 

 

There you go... you have a 50-50 chance...

 

With all things considered, this is about normal in many trading methodologies.

[brownsfan019 17]

If you assume that it will fill the current session 50% of the time, then that is something to work with. The next step would be how many bullets to fire to achieve maximum profit w/ minimum losses.

 

The 50% stat is an interesting one if there was a verifiable source.

 

Like I said, it never worked for me and I thought I'd post to see if anyone is trading gaps successfully. When it works, it's such an easy trade. When it doesn't, it can get messy if you continue to fire.

[simterann22 10]

Check out masterthegap.com

 

I subscribed to Scott Andrews' service for a couple of months. He uses statistical data to trade the opening gap everyday in the eminis.....plus pivot points etc. He does a pretty good job of it. I stopped subscribing because I wasn't trading futures at the time....now I am...so I'll probably subscribe again.

He put out a book called "Understanding Gaps" which is useful

[atto 20]

I have a decent amount of experience here, so will share some if anyone wants to look into this. I have an automatic strategy that trades gaps on ES that has a fairly impressive track record. This isn't my primary method of trading, but was one of my first statistical looks at markets, and has helped smooth out the P/L curve. It trades using statistical biases I've found, and only actually attempts roughly 20-25% of the time (but it's actually highly accurate, and has a good r:r). In turn, many of the "gap and go" days are filtered out.

 

For those who are statistically inclined, here are some things to look into regarding statistical biases for gaps. Remember, if the gap filled or not is only one side of the coin. Also look at the bias in context of the gap size and risk.

• Is the general market trending or congesting?
  
• How big is the gap? (I have filters for gaps that are too big, and too small)
  
• How does gap size compare to ATR? (same)
  
• Have the previous x gaps filled? (look at both the direction of the gap, and against)
  
• How does gap direction compare to the trend direction? (look at a few timeframes)
  
• Where is the gap positioned compared to the previous day's value area? (ie, is there liquidity close by?)
  
• Where is the gap located compared to yesterday's High and Low? (inside/outside)
  
• What day of the week is it? (yes, there's a bias)
  
• How volatile has the market been?
  
• Is the gap near S/R? (this is one of the hardest to automate, so sometimes you end up cutting corners)
  

 

This list is by no means complete, and I'd encourage someone who wants to delve into this look into these suggestions along with any other ideas they may have. I simply got a decent amount of historical data (think a couple years), and did some testing for each of my potential biases in Mathematica (Excel also works well for this) with a portion of the data. Once I had a good idea of a potential bias, I tested it on out of sample data.

 

When combined, these biases give you a much better idea of the statistical edge you may have by trading any given gap. I programmed the strategy to enter anywhere from 9:00 to 9:45 on a technical trigger (for brownsfan's case, he looked at hammers; you may prefer some type of indicator or other method). Exits are enabled within a certain % of the gap fill, and exit on a similar technical trigger (so they may go past the gap).

 

Hope this gives budding statisticians some ideas. In addition to biases, stop strategy is very important (and could be a bias in itself.. if price goes x% against, what's the chance it'll go back and fill?). Something mine does not do is the "bullets" approach, and there could be some validity in that.

 

Hope I didn't barge in on your candlestick discussion, browns

[BlowFish 10]

There was a study done... this was a long time ago, I do not have the reference anymore.

 

Basically it found that about 50% of the gaps were filled within the next oscillation...

some were eventually filled, e.g. 6 months later, which were of little use to a gap trader.

some were never filled.

 

 

There you go... you have a 50-50 chance...

 

With all things considered, this is about normal in many trading methodologies.

 

So for the 50 that get filled look at the maximum adverse excursion before filling and there you have the basis of a strategy (if MAE < gap)

 

Actually I might be inclined to look at some sort of internals/sentiment indicator to try and gauge.

 

Didn't some TA chap classify gaps as 'runaway gaps' or 'exhaustion gaps'?

[thrunner 10]

... Didn't some TA chap classify gaps as 'runaway gaps' or 'exhaustion gaps'?

In the days of old, before the merger was consummated, there was a chap named JC, who was pumping for CBOT, and he wrote this about the gap (not sure about the 'lowest risk' part, not sure about what JC wrote about the mini Dow and emini S&Ps, not sure about a lots of things JC wrote actually ...) :

These are critical steps and without them a trader is doomed to failure. I could write a couple of books on these subjects, but for the sake of this article, let's boil this down to the brass tacks: Traders who want to survive at this game have to understand gaps, and taking advantage of gaps using the CBOT mini-sized Dow contracts is one of the best ways to stay profitable.

 

Each day in the market there is one opportunity that represents the lowest risk trade available, and that is the opening gap. Gaps occur when the next day's regular session opening price is greater or lower than the previous day's regular session close, creating a "gap" in price levels on the charts. Gaps occur in many markets, but the key to making money on gaps is four-fold:

 

1. Knowing whether the gap is a break away or a fade.

2. Knowing how much time it needs to fill its gap.

3. Knowing how much of your equity to risk.

4. Playing gaps in the market most suited to your personality.

 

Before we take a look at how I play the gaps every day, I want to first take a look at the best market to utilize for these plays. Markets are a reflection of the traders who trade them. The emini S&Ps are a great market to trade if you are 22 years old and obtain 30% of your daily nutritional intake from Starbucks. This is a market made up of traders who are hyper-reactive, with many players trading thousands of contracts a day for quarter point gains. This is the type of intensity that can't last and burns people out. On the flip side, if a trader is more methodical and takes more than half an hour to decide which socks to wear with a pair of gray pants, then trading Exxon-Mobile (XOM) stock is going to be right up their alley.

Edited May 22, 2009 by thrunner

[zdo 20]

Bf

 

I only fade a gap if it is into a ‘fib’ cluster or cycle extreme. SR would work too. These days I also filter with the nature of how the gap was formed in the overnight - really no such thing as a gap anymore. hth

[programmer 10]

Bf

 

I only fade a gap if it is into a ‘fib’ cluster or cycle extreme. SR would work too. These days I also filter with the nature of how the gap was formed in the overnight - really no such thing as a gap anymore. hth

 

I agree ZDO.

 

About a year ago TRO coded a strategy for TS that seeks to filter only stocks with gaps (X) and calc the odds that X would fill based on historical stats (I think its on Kreslik.com), if anybody wants to check it out.

 

The nature of a gaps is enthused buying/selling which if negative to the open can put the market maker in trouble sometimes thus making them to seek "closure" and thus join the gap fill party, however today market makers are totally unpredictable even on that.

I do not use gaps anymore apart from ZDO's approach.

[bathrobe 10]

I used to get the TTM free videos and they claimed that a gap (cannot remember if it was on ES or YM) had a 62% chance of a half-fill and if a half-fill happened then an 82% chance of complete fill.

 

You could definitely put the odds more in your favor by using candlestick patterns as Brownsfan pointed out in the first post.

[brownsfan019 17]

A couple examples from this week:

 

 

 

 

 

 

2 perfect, super easy trades. 1 trade and done.

 

In the first chart, you'd want to hold most of the day. In the 2nd chart, exiting near the gap fill is ideal.

 

So there's a possible entry system here (with the biggest question being how many bullets to fire), which then leads to the next part of the equation - where/how/when to take profits.

[brownsfan019 17]

Looking at the charts, if you trailed your profit on the candles once the gap was filled, the previous charts could look like:

 

 

 

 

 

 

On trades w/ decent moves (like first one), this could provide some additional profits vs. covering at the gap. In the 2nd example, it yields more than covering at the gap level, just not as much as the 1st chart.

 

So there's an idea for exits for anyone doing some work on this idea.

[brownsfan019 17]

This is more of a price action / plotting support/resistance type chart, but we are in the candlestick corner and it's my area.

 

 

Here is May 28th chart after I marked it all up. The basic premise is old resistance becomes new support and vice versa.

 

[sevensa 10]

Hi Brown

 

Maybe a bit off topic, but you opened the door with your candle commets... Feel free to move somewhere else to keep this thread on track with gaps.

 

I've only been using very basic candle patterns up to now and is trying to expand a bit on that. When you say at point 2 that there were nice looking candle reversals, what are you looking at? Is it the two small bodies showing uncertainty after the wide up bar followed by the engulfing looking down bar that happened at the right place, i.e. against a possible resistance zone?

[BlowFish 10]

I think you ordered the AL Brooks book Brown? (I did too). In his presentations he talks about gaps, he is neutral on direction until price action dictates it. however his observation is that gaps frequently result in trend days (one direction or the other).

[brownsfan019 17]

Hi Brown

 

Maybe a bit off topic, but you opened the door with your candle commets... Feel free to move somewhere else to keep this thread on track with gaps.

 

I've only been using very basic candle patterns up to now and is trying to expand a bit on that. When you say at point 2 that there were nice looking candle reversals, what are you looking at? Is it the two small bodies showing uncertainty after the wide up bar followed by the engulfing looking down bar that happened at the right place, i.e. against a possible resistance zone?

 

Not off topic at all. Hell, it's mainly me talking to myself here so I welcome all company.

 

In regards to your question - at point #2 on the referenced chart, I see 3 very bearish/indecisive candles (spinning top, spinning top, bearish inverted hammer thing). The names of the candles are irrelevant in my eyes. What I see is 2 candles of indecisiveness and then a very bearish candle, ALL OCCURRING AT A RESISTANCE LEVEL. That's the only reason I would be interested in shorting here - we are testing the previous high which was also where a gap short (that worked) occurred. I would be willing to short there w/ a stop just above that HOD and see what happens. The risk/reward there is great.

[brownsfan019 17]

I think you ordered the AL Brooks book Brown? (I did too). In his presentations he talks about gaps, he is neutral on direction until price action dictates it. however his observation is that gaps frequently result in trend days (one direction or the other).

 

BF - thanks for sharing that as haven't read anything this week w/ some illness I'm fighting.

 

If you can expand more, please do. Curious to hear what he has to say on gaps.

[BlowFish 10]

The book didn't arrive in time for my weekend away, however the free info (linked in the other thread) has a wealth of information. I don't know why but I thought you had ordered the book too?

 

He pretty much does what you have mentioned and that is look for strength or weakness in the first couple of bars/candles after the gap. He doesn't make any assumption on direction (fill or further move in the gap direction) but his observation is that gaps often lead to strong trends so he gets ready for that eventuality.

[dancorcal 10]

Hi Guys,

 

I found this somewhere, and thought it could be useful. It states the half gap fill is 80% winner. Of course you will still need correct money management (i.e. position size, stop loss) to make it profitable. Keep the ideas coming.

Gap Play Data.xls

[brownsfan019 17]

If you can assume an 80% win rate, then this has very strong potential. Cutting losses is key.

[brownsfan019 17]

The book didn't arrive in time for my weekend away, however the free info (linked in the other thread) has a wealth of information. I don't know why but I thought you had ordered the book too?

 

He pretty much does what you have mentioned and that is look for strength or weakness in the first couple of bars/candles after the gap. He doesn't make any assumption on direction (fill or further move in the gap direction) but his observation is that gaps often lead to strong trends so he gets ready for that eventuality.

 

BF - I got it, but haven't opened it yet. Was planning to until I got hit w/ some bug that just shut me down for a good part of the week.