In the course of my brokerage career, I have spoken to hundreds of novice traders or people studying the futures markets.  One concern new traders often express is opening gaps.

Before electronic trading, there might be a long period of time between market sessions for many markets.  In the grain futures markets, for example, they would close at 1:15 PM and not trade again until 9:30 AM the following morning.  That was a long time for factors to come up to affect the market’s price.  If the market is closed, prices can’t react to changing fundamentals.

The spread of electronic trading has also extended the trading hours for many markets-computer servers don’t need to sleep!  This means that trading is more seamless, as markets can react to new data in real time.  Electronic trading has reduced the number of opening gaps, and helps clients manage risk better.

Opening gaps still do occur on occasion, however, and astute traders can actually use gaps to their advantage.  A great way to do this is to fade opening gaps.  I use Larry Williams’ name for these setups, calling them “Oops” Trades.

An Oops trade occurs when a market gaps higher or lower, then reverses course to fill in the gap.  An opening gap generally occurs when there is some sort of market shock.  Traders react to the shock by pushing the market sharply higher or lower on the open.

There are two things a market can do when it gaps on the open.  It can continue the move in the direction of the gap-I call these “Gap and Go” trades.  These occur when there is heavy participation on the open.

Sometimes there isn’t as much “buy in” to a gap opening.  When this occurs, the market tends to fall back to fill in the gap. As it fills in, the pressure increases in that direction.

Below is the daily chart of December Cocoa futures.  Yesterday’s high was 3117.  Today’s open was 3130, a gap higher.  What we’re looking to do is to sell short when the market drops back below the previous day’s high.   As the gap gets filled, we look for the selloff to continue.

Once you’re short, stop loss orders can be set a level with a comfortable amount of risk for you.  For this trade, I would have placed stops just above today’s open, or above the high of the day at 3150.  I generally look for chart points or retracement levels for profit targets.  I drew a line at the 3000 level-it was a double top in August, and a springboard to higher prices last week.

The psychology behind the Oops trade is that when these failed gaps occur, it’s generally the public that does the buying (in the case of an upside gap) to force the market higher.  The bigger pro traders either stand aside, or actively sell to the small traders.

As the buying pressure wanes, pros take advantage of the higher process by selling, pushing prices down.  As the price declines, the new longs get increasingly more nervous as their losses mount. These weak longs begin to sell out their now losing positions, adding to the selling pressure.  We, being the astute traders we are, sell short along with the pros to take advantage of them.

By watching market action, gaps can be something to not just avoid, but to be used to your advantage.

Oops in Action!

Oops in Action!

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