Arguably, the single most stressful event for investors and traders alike is the large, opening gap. They tend to happen when you least expect them and often result in the "deer in the headlights" effect as the trader tries to determine whether to fade (trade in the opposite direction) or follow (trade in the same direction) the gap.
Let's examine a historically profitable technique for trading large opening gaps in the stocks indices like the S&P 500 (SPY or ES) with a simple set of rules that can be easily remembered and executed.
There are two potential scenarios:
- The S&P 500 closes below the 10-day moving average (MA) and then opens at 9:30 a.m. ET with a large gap up above the prior session's close, or
- The S&P 500 closes above the 10-day MA and opens the next day with a large gap down.
For the purpose of discussion here, a "large" gap is one that is at least 40% of the five day Average True Range (ATR) in size. ATR is the difference between the high and low of a session's trading range, inclusive of any opening gap.
Simply "follow" the big gap by entering in the direction of the opening gap at the open (9:30 a.m. ET) or shortly thereafter. For example, if the gap opens "down" (i.e. below the prior day closing price), go short by selling.
Or, if the gap opens "up" (i.e. above the prior day closing price), go long by buying (see example in Figure 1 below). Close the trade at the end of the regular trading session (4:00 p.m. ET or 4:15 p.m. ET). Repeat every time this event occurs during the course of the year.
Back-testing this strategy for the past ten years shows attractive historical results. There have been 141 "long" signals, with 89 (63%) resulting in winning trades. Gross profits exceeded gross losses by almost 2:1 (profit factor = 1.98).
Short signals have not fared as well, but are worth considering with 96 winners out of 190 total trades (51%) and gross profits exceeding losses by about 40% (profit factor = 1.39).
This simple "follow the gap" strategy works for two reasons. It only triggers when the size of the gap is large, which implies that the balance of buying and selling pressure is skewed and that the markets may be ready to trend.
Finally, it takes advantage of the historical "reversion to the mean" bias of the equity markets. The indices naturally ebb and flow, so simply trading in the opposite direction of the most recent prevailing trend can be profitable if waiting for a trigger, such as a large opening gap. If prices do not fill the gap by retracing to the prior day close by the end of session, additional profits can often be captured by holding the position until the next day, or beyond.
Here is more information to understand gaps.