Trading the Stock Market’s Opening Gaps

Kevin Dixon |

Mind_the_Gap.jpg

Each day, the stock market has many different moving parts that combine to create potential opportunities for day trading. Earnings releases, analyst upgrades or downgrades, geopolitical occurrences or news of public opinion, rate announcements or other monthly/weekly news events drive price before, during and in the afterhours of every trading day.

How can a day trader capitalize on these opportunities consistently?

I would like to offer a day trading strategy that the market will “give” you each day: The Opening Gap plays known as “Fade the Gap” and “Fill the Gap.” Both are considered contrarian strategies, since we might look to take the other direction from the OPEN under specific conditions.

Why Would We Do that? 

When you take profits on a long trade, you SELL to close just as you BUY to close a short sell position. The GAP Strategies are designed to offer a potential scalping opportunity into this closing action!

Definition of “Opening Gap”

Gaps are the change in the price of a security from the PREVIOUS CLOSE to the DAY OPEN for the next trading session. GAPS ONLY OCCUR at DAY OPEN, hence the term Opening Gap.

If the price of the stock opens HIGHER than the PREVIOUS close, this is called a “Gap Up.” In other words, you will see an opening price that is above the previous close. IF the price of the stock opens LOWER from the PREVIOUS close, this is referred to as a “Gap Down,” as the current stock price is trading below yesterday’s close at open.

Gaps happen in any market you trade due to the fact that things happen before or after market which influence price as mentioned previously. For a gap to potentially occur, we just need a market close and then a market open.

I mentioned the market will “give” you these trades each day. But how do you identify which strategy and direction to trade, and the stocks that match the criteria?

The day trading strategies FADING the GAP or FILLING the GAP are technical strategies created by two key combinations: VOLUME and PRICE.

FADE the GAP: Fade the Gap refers to short selling a stock that has opened at a higher value than the previous closing price. The FADE is like a golf shot – you wait for the pullback off of market strength to enter a short sell scalp.

WHY THIS TRADE WORKS:

As traders are taking profit off of their long positions, we can scalp into this brief selling and trade with that momentum.

Here is an example of a FADE the GAP:

ALTR_4_27.jpg

Notice how the price opens significantly higher from the previous close, thus creating the gap, and then the sellers step in to take profits!

ORDER ENTRY and TARGET GOALS: We use a market order for entry due to the fact that this is a scalping strategy to start. As a scalping strategy, we are looking to enter with an initial target and stop of about 0.5% the price of the stock. EXAMPLE: A $50 stock would have a goal of $0.25 to start and an equal stop. The stop can be trailed, but should never become greater. The TARGET can be trailed once it is achieved to open up more profit potential.

 FILL the GAP: Filling the Gap refers to buying a stock that has opened at a lower value than the previous closing price. The FILL is like a cup of water – you wait for the pullback off of market lows to enter a long scalp trade, filling back the price difference from previous close.

WHY THIS TRADE WORKS: As traders are taking profit off of their short positions, we can scalp into this brief buying pressure and trade with that price action.

Here is an example of a FILL the GAP:

Lumber_Liquidators_4_27.jpg

See how the price opens markedly lower from the previous close, creating the gap, and then the buyers step in to take profits and close those shorts? We trade into this momentum and ride it out until either limiting out at target, or until the trade loses steam.

ORDER ENTRY and TARGET GOALS

We use a market order for entry due to the fact that this is a scalping strategy to start. As a scalping strategy, we are looking to enter with an initial target and stop of about 0.5% the price of the stock. EXAMPLE: A $50 stock would have a goal of $0.25 to start and an equal stop. The stop can be trailed but should never become greater. The TARGET can be trailed once it is achieved to open up more profit potential.

Remember, these stocks are gapping higher or lower for a reason! There is the potential to completely reverse the day’s action and erase the gap altogether, but the approach is always the same: “Taking pennies off of the railroad tracks.”

How Do I Find These Trades?

Here is my criteria for STOCK SELECTION:

PRICE ACTION: Only choose to trade stocks that are trading above or below 4% MINIMUM in the PREMARKET. This is critical, as we are playing gaps. We want to ensure that there is enough gap to trade. I will NOT SHORT STOCKS below $10 in PRICE on GAP PLAYS. You can buy stocks in your price range, but shorting requires specific average daily volume rules.

VOLUME: I look for PRE-MARKET volume of over 10,000 shares and the more the better! DO NOT TRADE this STRATEGY on LOW VOLUME STOCKS! The bid/ask spread is pretty open in the first 10 to 15 minutes of market, so trading low volume is a bad idea, since this will drive up your transaction costs, negating some of our scalping profits.

Avoid the Following:

  • SHORT stocks that trade below one million shares per day.
  • SHORT stocks below $10 in value.
  • BUY stocks below $5.
  • TRADE OPTIONS on this strategy - it is an opening gap play, and the spreads can be too high on options in the first 30 minutes.
  • Get greedy! Take what the market gives you and move on to the next trade.

Once you get the nuances down, you can get to work. The approach to the trade is the exact same way every time.

Plan to take 1% a day from the strategy. One percent a day equals 240% a year of potential trading profits in your account.

Remember – ALWAYS paper trade any strategy to learn the variables before trading with your live account. Take some time, and watch the OPENING GAPS…you may find profits easier than you think!

By Kevin Dixon of Market Traders Institute

Note: This is an actual screenshot for from Kevin Dixon's account via Market Traders Institute's Ultimate Charting Software.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
ALTR Altera Corp. n/a n/a n/a 0
LL Lumber Liquidators Holdings Inc 17.56 0.17 0.98 405,407

Comments

Emerging Growth

Veritas Pharma Inc.

Veritas Pharma Inc, formerly Seashore Organic Medicine Inc is an emerging producer and distributor of medical marijuana.

Private Markets

Almond Smart Home Router by Securifi

Securifi sells user friendly touch screen routers that also have support for IoT/home automation.Securifi’s Almond revolutionized wireless router setup with its easy to use Touchscreen Interface in 2012. Now our…

Wealthfront

Wealthfront is an automated investment service that serves as an alternative to traditional financial advisory services. The company manages a diversified, continually rebalanced portfolio of index funds on their clients’…