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Profit From the Opening Gap

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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.

THE SET-UP

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.

DEFINING TERMS

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.

GETTING IN

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.

CRUNCHING NUMBERS

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).

THE TAKEAWAY

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.

Gap Trading S&P 500 Chart

Here is more information to understand gaps.

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6 Comments

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Visitor - Trader1:
I notice that this is an old post by you, but I have just seen it.

Can you clarify your tems? Do you truly mean a 10 day moving average or actually a 10 period moving average on a 5 minute chart? Also, is it SMA or EMA, or does it not matter for this restricted interval.
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Visitor - ScottAndrews: This test uses the 10 day SMA (simple moving average). My guess is that the 10 day EMA would provide similar results.
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LaneMen: Great question....I look forward to Scott's reply...
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njorogem: What if it closes below the 10 day moving average and on next trading day Gaps down even more? Or vice versa.
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LaneMen: That's a very good question....look forward to Scott's reply....
ScottAndrews: In that case, fading (going the opposite direction) the opening gap (in your example, it would be to buy the down gap) works best. In fact, about 70% of all opening gaps in the indices fill the same day they are created. (You can learn more about fading the gap at my website www.masterthegap.com if interested. ) The purpose of this article was to highlight a scenario when 'following' the gap is better. Thanks for the question.
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About the Author

Scott Andrews, a former public company CEO, is a veteran, quantitative trader and founder of two online education services that provide daily probabilities and tools: www.ClosingOdds.com and www.MasterTheGap.com.  Mr. Andrews is the author of Understanding Gaps and many research studies and articles on technical and quantitative trading.  Prior to his trading career, he co-founded SciQuest (symbol: SQI) and took the company public as CEO.  He earned his MBA from the University of North Carolina and graduated from the United States Military Academy at West Point.  Mr. Andrews proudly served his country as an Army Aviator and is a decorated veteran of the first Gulf War.  He resides in North Carolina with his wife and four daughters.

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