Gap Trading Techniques 1. Morning Reversal Strategy
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2. Trading The Overnight Gap
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3. Trading The Opening Gap
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4. Gap Closer
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TRADING Strategies
Morning REVERSAL strategy Historical tests reveal the tendency of the major stock indices to revert to the previous day’s closing price in the early minutes of the trading session. This strategy takes its cue from that bit of market behavior. BY BRYAN C. BABCOCK AND ARTHUR AGNELLI
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inding a strategy that backtests successfully is rare; finding one that is reproducible in live trading is rarer still. The following intraday strategy — the Morning Gap Reversal (MGR) — capitalizes on the major indices’ tendency to retrace toward the prior day’s close each morning. It has a high winning percentage tested in both bull and bear conditions — an important characteristic for any shortterm strategy — and it is easy to execute. Each morning the opening price of an index or stock is higher or lower than the
prior day’s closing price. This price change is called the morning gap if it is above the previous day’s high (an “up gap”) or below the previous day’s low (a “down gap”). However, for simplicity, we will use “gap” to refer to the distance between the previous close and current open, regardless of whether or not the open falls within the previous day’s range (see Figure 1). First, we will analyze the behavior of morning gaps to determine if they provide a logical basis for a trading strategy.
Morning gap statistics
Statistically, price has a very high likelihood of filling between 50 and 100 percent of the gap between yesterday’s close and today’s open during the trading day. Usually, a reversal that fills (or partially fills) the gap will occur within the first 30 minutes of trading (by 10 a.m. ET). Three years of back-testing from January 1999 to January 2003 on the Dow Jones Industrial Average (INDU), S&P 500 (SPX) and Nasdaq 100 (NDX) indices was conducted to verify the statistical reliability of the basis for the MGR strategy. The analysis was FIGURE 1 MORNING “GAPS”: REVERTING TO THE CLOSE divided into three parts: first, deterIn the first half-hour of the trading session, the market will frequently retrace in mining the frequency and extent of the direction of the previous day’s close. morning gap reversals; second, finding out how quickly morning gaps S&P 500 index-tracking stock (SPY), 88.97 reversed; and third, identifying one-minute 88.92 important “time markers” within 88.88 the reversal period. 88.84 88.80 Table 1 summarizes the first part 88.76 of the analysis. The columns show Market open price 88.72 different gap sizes, from 1 to 3 per88.68 cent (positive or negative). The rows 88.64 88.60 show what percentage of the gaps 88.56 were filled, and the cells show how 88.52 often they were filled (at some point 88.48 during the trading session). 88.44 Reversal 88.40 The table shows 85 percent of the 88.36 gaps between zero and 1 percent in Gap up 88.32 size (positive or negative) closed at 88.28 least halfway, and 78 percent of the 88.24 88.20 gaps closed between 90 and 100 per88.16 cent. 88.12 Although slightly less reliable, Prior day close 88.08 gaps between 1 and 2 percent (posi88.04 88.01 tive or negative) showed a similar 1/22 15:40 15:45 15:50 15:55 1/23 9:35 9:40 9:45 9:50 9:55 10:00 10:05 10:10 tendency to be partially retraced or Source: Great-Trade by Protrader 2
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filled. These gaps retraced by at least half 78 percent of the time and retraced between 90 and 100 percent 62 percent of the mornings studied. Gaps in the 2- to 3-percent range were somewhat less likely to be filled. Only 14 percent of the gaps (in the “Overall” column) closed between zero and 9 percent, which includes those mornings when price immediately moved in the opposite direction of the gap closure, creating what is known as a “gap and run.” The second part of the analysis explored how quickly gaps reversed. The gaps typically closed half way (50 percent) by 9:55 a.m. Of the gaps that closed completely, 67 percent of them did so in the first 30 minutes of the trading session, and 86 percent closed by the end of the first hour of trading (10:30 a.m. ET). The likelihood of additional closure declined substantially after the first hour of trading. Gaps that were still open after 60 minutes closed only 4.5 percent of the time. Also, the success rate diminished on days when economic news was released 30 minutes after the market open, at 10 a.m. ET. The third portion of the analysis identified important time markers during the gap-reversal period. Figure 2 (below) shows the typical time markers for gap reversals. Just after the open, the major indices tended to continue to move in the
TABLE 1 MORNING GAP ANALYSIS direction of the The columns show morning gaps of different sizes. opening price for The rows indicate how much of the gaps were filled. the first one to 10 minutes. After Gap size this initial rally % of gap closed +/-1% +/-1 to +/-2% +/-2 to +/-3% Overall (or sell-off), the 0-9 12 8 19 14 market turned and began to 10-19 0 2 5 2 close the morn20-29 1 6 5 2 ing gap. This 30-39 1 4 6 2 reversal, on aver40-49 1 2 5 1 age, began six 50-59 2 5 2 1 minutes after the 60-69 1 7 4 2 open, at 9:36 a.m. 70-79 2 1 4 2 ET. The typical 80-89 2 3 2 2 reversal was 90-100 78 62 48 72 maximized at 50% 85 78 60 79 9:53 a.m. ET. An approximately fourminute countertrend move (or “jig,” futures quotes are also available through which often fakes out traders into coverthe Chicago Mercantile Exchange Web ing positions early) typically occurred site, www.cme.com.) Whether these conaround 9:42 a.m. and lasted until approxtracts are trading up or down in the early imately 9:47 a.m. morning can give you an indication of the possible direction of the stock market Before the bell: open. Pre-market review process Second, make note of how the futures The first step in trading the MGR is antic- are affected in the pre-market by any ipating the direction of the opening economic reports released at 8:30 a.m. move. Usually two hours before the marET. This will indicate whether the ket opens a reliable gap can be identified futures are strengthening or weakening by checking the pre-market stock index in pre-market trading. Make a final futures quotes on CNBC or Bloomberg check of the futures at 9:10 a.m. (20 min TV. (Minute by minute pre-market index utes prior to the market open).
FIGURE 2A MORNING UP-GAP TIME MARKERS
FIGURE 2B MORNING DOWN-GAP TIME MARKERS
The primary time “milestones” in early trading show the retracement to the previous close typically maximizes around 9:53 a.m.
The time markers for the typical down gap are the same as those for up gaps.
Morning open — up gap
Prior day closing price
Morning peak on average 9:36 a.m. EST
Trade is maximized 9:53 a.m.
Price “jig” — usually 9:42-9:47 a.m. Trade is maximized 9:53 a.m.
Prior day closing price
Morning open — down gap
ACTIVE TRADER • May 2003 • www.activetradermag.com
Price “jig” — usually 9:42-9:47 a.m. Morning bottom on average 9:36 a.m. EST
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FIGURE 3 PATTERN ENTRY One way to enter a trade is to wait for two consecutive bars that close lower than they open (in the case of a downward reversal and potential short trade), with the second bar also having a lower low than the first bar
The pattern entry approach waits for the market to reverse toward the previous closing price before entering the trade. The trade is taken only after two complete one-minute bars 88.97 S&P 500 index-tracking stock (SPY), one-minute in the direction of the reversal (i.e., 88.92 bars with closes below their opens, 88.88 88.84 and the second bar with a lower low 88.80 than the previous bar, if the reversal 88.76 direction is down), as shown in 88.72 Figure 3). The advantage of this 88.68 approach is that by waiting for the 8 8 . 6 4 Pattern entry: 88.60 market to confirm the reversal prior consecutive bearish 88.56 to entry, the trader avoids entering a one-minute bars in the 88.52 losing position on days when the direction of the reversal. 88.48 market keeps running in the direc88.44 tion of the opening gap. The disad88.40 88.36 vantage is that the trader is always 88.32 late getting into the market and may 88.28 miss significant profits as a result. 88.24 The staggered entry combines the 88.20 first two approaches by breaking 88.16 88.12 the entry into two equal halves. The 88.08 first half of the trade is placed at 9:31 88.04 a.m. and the second half of the trade 88.01 1/22 15:42 15:46 15:50 15:54 15:58 16:02 16:06 16:10 16:14 16:18 16:22 16:26 1/23 9:32 9:36 is entered after two bearish oneSource: Great-Trade by Protrader minute bars in the direction of the reversal. This way, if the market reverses quickly, the trader has a There are two qualifications for the open just above established support. partial position already in the market. behavior of the futures in pre-market Both indices and stocks exhibit the However, if the market runs in the directrading. First, all three index futures con- morning gap characteristics outlined tion of the open, only half the trade is tracts (S&P, Nasdaq 100 and Dow) must here. Index-tracking stocks such as exposed. trade consistently in the same direction QQQ, DIA, or SPY are good vehicles for during the pre-market. For example, if trading the MGR strategy because, not Stop placement the Dow futures are down 35 points at 8 being subject to the up tick rule, they are a.m. and rally to trade up 20 points by 9 easier to sell short than individual equi- Every trader’s primary focus should be a.m., they have changed from implying a ties. For these reasons, it is recommend- controlling risk and losses. Most traders are quick to take a small profit when the down opening to implying an up opened that you concentrate on the three market is willing to give a larger profit, ing. This kind of behavior should not be major index-tracking stocks when tradwhile at the same time they expose themtraded. Similarly, if one contract is up ing the MGR strategy. selves to too much initial risk and are and the other is down (e.g., the Nasdaq is slow to take losses. The following guideup 5 and the Dow Jones is down 15), it is Trade entry lines are designed to let the market connot a good day to use the MGR strategy. The average reversal start time is 9:36 trol your profit while you control your Second, because a very narrow gap a.m., which means the trade-entry winrisk. reduces profit potential, gaps in the dow is generally from 9:30 to 9:42 a.m. If The strategy uses three kinds of stopfutures contracts must be in excess of 5 a position has not been initiated by 9:42 loss orders, the sizes of which are points for the S&P 500 futures, 10 points a.m., no trade is taken for the day. Three intended for SPY, DIA and QQQ. The for the Nasdaq 100 futures and 20 points entry techniques can be used with the first type is the “high-low” stop. The for the Dow Jones futures. MGR strategy: time entry, pattern entry primary risk in an MGR trade is the and staggered entry. market will continue to run in the direcOther factors A time entry consists of “playing the In addition to watching pre-market trad- averages” by entering a trade at 9:36 a.m., tion of the gap. Therefore, if the indexing activity, evaluate the support and regardless of what the market is doing at tracking stock trades 15 cents above the highest high of the morning (for up resistance in the market you intend to the time. This approach has the advantage gaps) or below the lowest low of the trade. Be aware of the projected opening of being easy to execute, but it also runs morning (for down gaps) after 9:45 a.m., price of the security relative to any sigthe risk of putting you immediately on the the position should be closed. This is the nificant support or resistance levels. losing side of the market. Despite these worst-case scenario and will yield the Often a market that is gapping up will disadvantages, a trader without a realstrategy’s largest losses. open just under an established resistance time trading setup system may prefer this The second stop-loss is a trailing stop level; a market gapping lower might method because of its simplicity. 4
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that requires evaluating where the FIGURE 4 SHORT-TRADE EXAMPLE trade is relative to the best price it In this case, the entire morning gap was filled in the first 20 minutes of trading, has experienced up to that point. at which point half the trade was liquidated and a 25-cent trailing stop was used to First, once a 25-cent profit has been protect the remainder. reached, move the stop to breakeven. When a 35-cent profit 84.274 Dow Jones Industrial Average index-tracking Initial stop-loss is placed at the is in place, trail the stop-loss 25 84.20 stock (DIA), one-minute morning high plus 15 cents cents above the highest high (for a 84.16 8 4.12 short trade) or below the lowest 84.08 Pattern entry 84.04 low (for a long trade) reached dur84.00 (Two consecutive one-minute ing the trade. 83.96 bars in the direction 8 3.92 For example, if the position is 83.88 Exit remainder of of the reversal) 83.84 up 35 cents and moves back to position at 9:55 a.m ET 83.80 being up only 10 cents, exit the 83.76 (83.47) Entry: 83.72 trade; if the position is up 50 cents 8 3.68 Price — 83.74 83.64 and moves back to being up only Time — 9:37 a.m. ET 83.60 25 cents, exit the trade. This 83.56 83.52 approach continually moves the 83.48 83.44 stop in the direction of the trade. 83.40 The third stop is the “time 83.36 83.32 stop.” Because this strategy is 83.28 8 3.24 most successful in the first 30 min83.20 utes of trading (and because eco83.16 83.12 Exit 50 percent of the position (at 83.24) when nomic announcements often occur 83.08 the entire morning gap is closed. 83.04 at 10 a.m. ET), the time stop liqui83.01 1/22 15:30 15:35 15:40 15:45 15:50 15:55 1/23 9:35 9:40 9:45 9:50 9:55 10:00 dates any position that is still open at 9:55 a.m.. This allows the trader Source: Great-Trade by Protrader to take advantage of the most benHowever, when the gap closes entiretechnique could have been used.) eficial time period without exposing the ly before 9:55 a.m., half the position The market continued to move lower, trade to the volatility of adverse reacshould be closed. (The prior day’s close first reaching the 25-cent profit level at tions to news. is a natural resistance/support level; if it approximately 9:41 a.m., at which point In actual trading, the majority of losing trades are stopped out with a loss of is penetrated, the possibility of a turn- the stop is moved to breakeven. Next, around off that level emerges.) The sec- DIA reaches the prior day’s closing price 50 cents or less. In tests, a 50-cent ond half of the position should be kept around 9:48 a.m. When this target was absolute stop in the SPY and DIA was open in case the market continues to reached, 50 percent of the position was rarely hit. The lower price of the QQQ move profitably. closed for a 50-cent profit. made them even less susceptible to being Finally, the “jig” mentioned in the staFrom this point onward, the balance of hit; the typical maximum loss in the tistics section occurs quite frequently the position would be exited with the 25QQQ is closer to 30 cents than 50 cents. between 9:42 and 9:47 a.m. ET. Because cent trailing stop or at 9:55 a.m., whichevthis countertrend move can fool a trader er comes first. In this case, the time stop Position sizing was reached, closing the second half of Correct position sizing will enable you into closing a position too quickly, try to to focus on the strategy without being avoid closing a position during this time the trade at $83.47 for a 27-cent profit. The frame. Stick to your original stop-loss trade’s total profit was just over 38 cents, distracted by unnecessary anxiety. A levels. taking into account the two exits. conservative money management benchmark is to risk no more than 2 perStatistical foundation cent of account equity on a trade. This Trade example Figure 4 shows the Dow Jones Industrial and tight risk control means a trading account of $25,000 Average tracking stock (DIA) opening The MGR strategy is based on the favorcould afford to risk $500 per trade higher (on Jan. 23, 2003) than the precedable statistical performance of early ($25,000 x .02 = $500). Because this strategy typically stops out a losing trade ing close, setting up a potential short morning reversals back to the previous day’s closing price. It combines a high within 50 cents of the entry, it’s possible sale. Using the simplest entry approach, a winning percentage with conservative to trade up to 1,000 ($0.50 x 1,000 = $500) short trade was entered at 9:37 a.m. ET at risk management. shares. $83.74 (the market was already starting The strategy’s simplicity makes it to retrace toward the previous closing easy to monitor and “paper-trade” in Caveats price of $83.24). The initial stop-loss was real-time, which lays the groundwork The stop-loss rules are structured to let placed at $84.07, which corresponds to for actual trading. Ý the market determine how large the profit should become when the trade the morning high plus 15 cents. (The chart also shows where the pattern entry For information on the authors see p. 12. runs in the desired direction. ACTIVE TRADER • May 2003 • www.activetradermag.com
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TRADING Strategies
Trading the overnight With increasingly reactionary markets
GAP
comes the higher risk of opening gaps. Learn how to spot the early warning signs and how to take advantage of them.
BY DAVID S. NASSAR
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n today’s markets, many stocks can have large supply-demand imbalances at the opening bell. Often, these imbalances result in what are known as gaps, when the opening price is higher or lower than the preceding close. News, in various forms, is generally the catalyst for gap openings. The most common type is macroeconomic news such as FOMC meetings, the release of economic indicators such as unemployment or the Consumer Price Index (CPI), or stock-specific news such as earnings surprises or analyst upgrades or downgrades.
When buying interest exceeds selling interest, the gap will obviously be to the upside and vice versa. However, what is not known is the price level at which the stock will open, and the precise risks associated with being long or short in a particular situation. Until recently, these price levels were often determined exclusively by large “off-floor” markets, such as Instinet, an institutional trading network that was the first outside-market-hours trading medium. Today, with the advent of many other Electronic Communications Networks (ECNs), there are many more retail traders active in pre- and postmarket trading. However, even though the public has access to the pre-market, the levels that trade pre-market are still mostly influenced by market makers who bid or offer stock at price levels away from the previous day’s close when imbalances appear in their automated systems. Because many of these imbalanced orders are “market on open orders” (meaning they are to be executed at the “best” available price as soon as the mar-
ket opens), market makers have an incentive to open a stock at extreme levels directly correlated to the imbalance. This simply means that if an imbalance is on the demand side, and a given stock is going to open strong, market makers will open it as high as they can, taking the opposite side of the trade on open buy orders. Because most members of the public trade only the long side of the market, many unsuspecting amateurs buy into gap-up openings at what often will be the high price of the day. As a result, it is worthwhile to explore the possibility of trading situations when a gap will not hold (reverses), rather than those instances when the stock follows through with a move in the same direction. Whether the stock reverses and closes the gap or follows through in the same direction, this move is perhaps the strongest indication of what the trend will be for the stock shortly after the gap opening. In the example of bullish gaps, stocks that fail to meet new highs from the opening levels will have a greater likelihood to retrace and lose much of
The first clue that a stock is ripe for a gap opening is an increase in volume over its normal daily average. 6
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FIGURE 1 CHARGING LOWER Starting in September 2000, the uptrend in Intel (top chart) came to a halt, punctuated by a series of downside gaps. Typically viewed as a blue-chip stock free of extreme volatility, Intel became much more volatile after the first down gap; it became a "charged" stock that propelled the entire semiconductor sector lower (bottom chart). the opening gap. Conversely, stocks that remain strong and trade to new highs after the opening gap will have a greater likelihood of following through and trending higher. While this shouldn’t be interpreted too rigidly (there are other indicators to monitor, such as index strength and sector strength, etc.), it is the strongest single indication of how a stock will trade following a gap opening. Regardless of whether gaps are to the upside or downside, it is important to study the impact they have on stocks. The following components and considerations are most important when trading gaps:
Intel (INTC), daily
75 70 65 60 55 50 45 401⁄32 39 35 300,000,000
Volume
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• Charged stocks/sectors; • Volume and volatility; • Chaos and over-activity; • High risk (elasticity).
5 Sept.
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18
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2 Oct.
9
16
23
30 Nov.
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1200.00 1150.00 1100.00 1050.00 1000.00 950.00 900.00 850.00 800.00 750.00 700.00 651.22
PHLX Semiconductor Sector Index (SOX), daily
Let’s look at each of these factors.
Where the action is: Charged stocks and sectors Once a sector is in the public eye, think of the component stocks as being pumped up or “charged.” When this occurs, the volume in the stock will increase, and there will be a tremendous swing in the trading range from one session to the next, either to the upside or downside. Before the opening bell, in the absence of actual trade activity, market makers will predict price pattern changes — either slightly before an event or immediately after one — and bid the stock higher or lower based on their predictions. If a major stock within a sector experiences negative or positive news, it can charge an entire sector. Figure 1 shows Intel (INTC) gapping down after negative news on inventories. The entire Philadelphia semi-conductor index (SOX) became charged and volatile
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100,000,000 74,009,300 0
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Source: QCharts by Quote.com
immediately after. As you can see from the chart, Intel did not hold its levels after the first gap and followed through by trending lower, as did the SOX index.
Early warning signs: Volume and volatility The first clue that a stock is ripe for a gap opening is an increase in volume over its normal daily average. Often, the volume
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increase will occur before the news is known. This is an indication that news is leaking in the market and explains the cliché “stocks tell their own story” ahead of news. Remember, the biggest trading houses often have strong indications of sector and stock strength/weakness before the media. Therefore, when increases in daily volume accompanied by directional bias are seen in the 7
absence of news, a gap is generally not far behind. The best way to track volume is by knowing the average daily volume for the stock or sector in question, in combination with its key trading levels (support or resistance). Watching the time and sales ticker is an excellent way to
heavy buying and selling, which result in small price movements until one side ultimately gains control. Once a clear imbalance is revealed, whether bullish or bearish, the volume tends to dry up as market participants start to lean over to one side of the supply/demand scale. For example, if the bulls gain control at a
get whipsawed out of trades, taking many losses. Certainly, you also need a clear picture of what the broader price action looks like before even thinking about adding volatile, big-range stocks to your watchlist. It is also important to dramatically lower your size in these trades, because the range of the price
Stocks tend to overreact and move to extreme price levels, which sets up the possibility of a correction in the next trading session. monitor changing volume for short-term intraday trades. If the ticker is moving fast, you are seeing an increase in volume — it’s that simple. When this occurs, you are generally looking at a “vertical spread” (VS) situation. A high VS means the price pattern is changing rapidly, up or down, and you will need to “lead” the market (i.e., place a limit order that is the best bid or offer) to buy or sell as the range widens. A slower-moving issue that has a tight “horizontal spread” (HS), where the spread between the bid and ask is tight, say 1⁄16, will not require leading. If the stock has a tight HS, you can easily “lift offers” or “hit bids” — or even buy bids and sell offers –— during tight price range situations. To spot volume changes that may lead to gaps, it is important to take a broader view of both the volume and the market itself. Notice the dramatic volume increase in Intel over the course of several days, in Figure 1. However, the volume interpretation changes within each move and the stock will move the most on the least volume once it is in motion. For example, when stocks are growing weaker, panic and fear is heightened and fewer buyers are stepping up. Therefore, as buyers disappear from the market, stocks fall harder on light volume and with a wider range before new support levels are found. Once the stock establishes support levels, the volume builds dramatically as buyers remain strong, while sellers are still in the market. It is at these levels that the true battle between bulls and bears takes place. These campaigns are evidenced by 8
key support level, buyers will exceed sellers and the stock will trade higher on less volume as the buyers lift thin offers at each price level. The lesson here is that volume indicates where the battles are fought between bulls and bears, but once a dominant bias is revealed, the stock will move the most on lighter volume. Gaps are the ultimate example of this: no volume exists, but extreme price change does. Once this gapping action begins, chaos is not far behind.
Chaos and high risk: Are gaps worth it for you? Chaos reaches its peak when stocks have no real support or resistance levels in sight. For example, if a stock is not well supported until it trades 20 points lower, volatility will be extreme. These such conditions represent a day-trading environment only. This is not a time to take overnight positions. Remember, volatility can also be defined as chaos and, therefore, you can throw your technical tools and indicators out the window. If you want to day trade in this climate, you must take a micro view of the stock, taking small incremental profits and losses vs. trying to trade the overall trend. Also important is that gaps often reveal the beginning of new trends. However, if you’re a longer-term position trader in these situations, you must have a much higher risk tolerance because these price fluctuations are part of the equation. Otherwise, you will constantly employ “discipline” at the wrong time (placing stops too close, etc.) and
swings offsets the trade size needed to profit. Seeing the broader view of the market is like a hurricane: When you’re in it, it is chaos, but if you can get far enough away, you can see the larger pattern and direction. When you trade chaotic stocks, you must trade them accordingly or avoid them altogether. To determine if a chaotic market climate in general, and the overnight-gap trade in particular, is for you, ask yourself the following questions: 1. Do I have the account size required to take the necessary risk? 2. Do I have the temperament and the required level of risk tolerance? 3. Am I “in the money” and willing to take on additional risk for additional reward? 4. Do I have clarity and confidence enough to see the gap coming? 5. Did I day trade this stock the entire day prior to the anticipated gap? If you answered “no” to any of these questions, don’t even think about taking the trade. If you answered “yes” to all of the questions, then you have the criteria to attempt it. Here’s how to do it.
Taking the trade Let’s begin with the fact that, because of volatile price pattern movements during the day, stocks will tend to overreact or overtrade, moving to extreme price levels that are extreme. This sets up a possible correction for the next trading session, when market makers will often gap the stock price to levels that are advantageous for them. The first gap that sets the stock in
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FIGURE 2 EARNINGS DISAPPOINTMENT Leading up to the earnings release on Oct. 27, shares of American Power Conversion (APCC) traded from 18 to 22 in five days. The earnings didn’t live up to expectations and the stock gapped nearly seven points lower the following day. American Power Conversion (APCC), 10-minute 22 21 20 19 18 17 16 15 14 13 1⁄16 Volume
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Source: QCharts by Quote.com
motion because of unforeseeable news is generally not predictable. However, the gaps that may follow can occur for some of the following reasons: • Additional news, such as earnings releases. • Short squeezes and profit taking (“hook” closes). • S&P 500 futures volatility. These different factors can provide various signals that offer opportunities for gap trades. Earnings. Earnings are perhaps the most significant factor regarding gap trades, because they have such a substantial impact on both stocks and sectors. The market is far more unforgiving of missed earnings than it is rewarding to earnings that meet estimates. Many companies meet expectations and still get hammered the day after their announce-
ments. This is because most positive earnings expectations are built into the stock price in the days prior to the report. For this reason, stocks have a greater propensity to fall when companies merely meet expectations. When expectations are missed, the downside bias is dramatic. Therefore, you should rarely take an overnight position in a company that is reporting earnings after the close. If you do, your natural bias should be to trade the short side — especially in this market environment, where good earnings are often no match for inflationary pressure, rising interest rates and oil prices. Because so many stocks have an upside bias in the days prior to an earnings report, it is best to sell into the news if you’re long the stock, and wait for the outcome. Figure 2 is an example of what companies experience when they miss
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expectations. Short squeezes and profit taking. Short squeezes and profit taking are the most common reasons stocks will tend to build above-average volume into the close and cause what is called a “hook” close. In a short squeeze, a stock is in a downtrend and market makers suspect there may be many short sellers in the market. The squeeze and the hook occur when the professionals begin to buy the stock rapidly into the close, causing price to rise swiftly and forcing the short sellers to cover in a panic. Profit taking generally occurs when a stock is in a rising trend but shows a weak close accompanied by high volume. At this point, traders with long positions begin to sell the stock to take a profit. Figure 3 shows an example of a short squeeze, while Figure 4 is an example of a hook formed 9
FIGURE 3 SHORT SQUEEZE On Oct. 26, Amgen (AMGN) closed the day near its high on a sudden spurt of buying that was likely the result of a short squeeze. A look at the intraday chart reveals the stock was in a downtrend, with the previous support level at 69 1⁄2 becoming resistance. Amgen (AMGN), 5-minute
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66
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60 59 1⁄8 1,200,000 1,057,900 1,000,000
Volume
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Source: QCharts by Quote.com
during profit taking. If you’re not in a profitable situation from day trading the stock, you should not take the overnight gap trade. It is best to stand aside and trade the open the following day, after the stock gaps open — if it does. If you had a profitable day-trading session, you can take the overnight position if you think the riskreward relationship is satisfactory. Remember, when going after an overnight position, it must always be with purpose and confidence. Never
hold a losing position overnight, hoping the stock will “come back.” That is nothing but gambling. S&P 500 futures. S&P 500 futures are an important consideration when taking an overnight gap trade. You should look at the correlation between the futures market and the index in relation to the gap-trading plan you have in mind. If the futures are moving decisively higher going into the close, and you have other independent reasons for the stock in question to gap higher the next day, and
The first gap that sets the stock in motion because of unforeseeable news is generally not predictable. 10
all other questions and factors can be answered favorably, you could keep your long position overnight. The point is you must have clarity and confirmation on all levels when taking a position overnight. Still, the most significant piece of information comes from the stock itself and how it behaved while you where trading and watching it in the days prior to the anticipated gap. Without this information, you will not be able to make a decision whether to take a gap trade or not. Gap trading is a risky business, and the professionals who quote stocks up or down prior to the open have a vested interest in doing so. If you were a market maker who made your living buying and selling stocks from the public while providing liquidity to the market, where would you open a stock with poor news knowing you were to receive market on
www.activetradermag.com • March 2001 • ACTIVE TRADER
FIGURE 4 PROFIT-TAKING Transwitch Corp. (TXCC) was on its way to recovery from a sell-off in the fiber optic group. Along the way, profit taking on Oct. 30 forced the price lower at the end of the day. The next morning the stock gapped higher, with the buyers once again firmly in control. Transwitch Corp. (TXCC), 5-minute
56 5⁄16 56 54 52 50 48 46 44 42
Volume
200,000 150,000 100,000 50,000 8,200
14
15
10
11
12 13 10/27 Friday
14
15
10
11 12 10/30 Monday
13
14
15
10
11 12 10/31 Tuesday
Source: QCharts by Quote.com
open orders? You would open it as low as possible, where you felt the stock was well supported. This is known (from the market maker’s perspective) as “buying weakness.” Conversely, with strong news, knowing you would be selling at the open, where would you open the stock? The higher the better, so that you could short
stock to buyers at what would be a significant resistance level. This is referred to as “selling strength.” This is why gaps have a greater propensity to close immediately after the open: After the initial panic selling or mania buying has been gobbled up by the market maker or specialist, a vacuum often develops and the stock will reverse.
By contrast, if the stock continues to follow-through in the direction of the gap, it’s a strong indication that the trend will continue. Remember, however, that while these rules are good to use as a guide, they should not be traded with indiscretion. There are many factors that impact any individual gap-trading situation. Ý
The market is far more unforgiving of missed earnings than it is rewarding to earnings that meet estimates. You should rarely take an overnight position in a company that is reporting earnings after the close. If you do, your natural bias should be to trade the short side. ACTIVE TRADER • March 2001 • www.activetradermag.com
11
&
FUTURES
Trading Strategies
OPTIONS
Trading the
OPENING GAP
Watching pre-market volume is a good way to determine whether to trade or fade the opening move.
BY JOHN CARTER
O
pening price gaps — the distance between the regular-session opening price and the previous day’s closing price — are stomach-churning events when the market makes a big move against you, but they represent low-risk trade opportunities if you know which gaps are likely to be followed by predictable patterns. In terms of the price behavior that follows opening gaps, not all markets are created equal. Gaps in individual stocks and commodities do not act the same as TABLE 1 FILLING THE OPENING GAP: RAW DATA Between Jan. 15, 2002, through February 2004 (528 occurrences), an average of 76 percent of all opening gaps closed at some point during the same day. This is the breakdown by day of week. Adding the pre-market volume filter increased the percentages. Day
Percentage of gaps filled
The best markets for gap plays The S&P 500 and the Dow are the best markets to trade the opening gap
because of the diversity of their component stocks. Both indices represent collections of stocks from different industries that are more likely to react independently to news events. In the technologyheavy Nasdaq, opening price gaps can take longer to fill because the majority of the stocks will react similarly to news. The key to trading opening gaps is being able to predict the likelihood a particular gap will be filled. Dissecting the market conditions that produce a gap is as important as analyzing a gap itself. For example, an opening gap following high pre-market cash trading volume can take weeks to get filled because high volume increases the odds the market will continue to move in the direction of the gap. Some of the biggest gaps are caused by major news events, such as the outbreak of a war, but gaps caused by minor news items are much more common. Generally, such gaps are smaller, fill quickly (see Table 1) and can be “faded” (the act of trading against the direction of the gap) more effectively. Let’s look at
TABLE 2 TRADE MANAGEMENT GUIDELINES The higher the volume, the greater the likelihood the market will continue in the direction of the opening gap. As a result, no trade is taken when vol ume is above 70,000.
Monday
65%
Pre-market volume in key stocks
Tuesday
77%
Less than 30,000
Full size
Exit entire position at gap fill
Wednesday
79% 82%
Between 30,000 and 70,000
2/3 size
Thursday
Exit half at 50 percent of gap fill, half at gap fill
Friday
78%
Above 70,000
Source: Tradethemarkets.com 12
those in “multi-item” instruments such as stock indices because a news item will control the entire market instead of just a portion of it. Earnings announcements, corporate scandals and other companyspecific events can create gaps in a component stock’s chart that never get filled. Because of the unpredictable nature of various events that can impact the price of an individual stock, they make poor candidates for the opening-gap trade. In contrast, stock index futures such as the E-mini S&P (ES) or the mini-sized Dow (YM) are better candidates for opening-gap plays because they consist of multiple components that respond differently to news. For example, although a stock index futures contract may gap up on a news item, there will be individual stocks within the index that will either ignore the news or sell off. This weighs the index down and creates a trade opportunity as the market fills the gap.
Position size
No “fade” trade
Trade target
No “fade” trade
Source: Tradethemarkets.com www.activetradermag.com • December 2004 • ACTIVE TRADER
the specific criteria for identifying those gaps with the best chances of reversing.
The pre-market volume indicator The most important indicator for determining which opening gaps can be faded is the pre-market volume in a specific set of stocks. Check the pre-market volume at 9:20 a.m. ET (10 minutes before the regular cash session opens) in the following stocks: KLA-Tencor Corporation (KLAC), Maxim Integrated Products, Inc. (MXIM), Novellus Systems, Inc. (NVLS) and Applied Materials, Inc. (AMAT). These representative stocks were selected through a trial-and-error process. If the market is really set up to move, there will be significant volume in the cash market in pre-market trading. If the market is setting up for a “head fake” (a move in one direction that is quickly reversed), pre-market volume will be low, which reflects a lack of conviction in the move. This is the preferred setting for an opening-gap trade. If the pre-market stocks have each traded less than 30,000 shares at this time, analysis of the prior 500 trading days shows the opening gap, up or down, had an 80-percent chance of filling the same day. However, if the volume for each stock is between 30,000 and 70,000, the gap only has about a 60percent chance of filling that day, while the midpoint of the gap has an 85-percent chance of being hit. Finally, if the pre-market volume for each stock is above 70,000, the chances of the gap filling that day drop to 30 percent. In these cases, you should ignore the news and follow the direction of the gap. Table 2 provides guidelines for using volume information to manage trades. As the volume increases, the position size shrinks and the profit-taking becomes more conservative. If one stock has volume above 70,000 but the others are below the threshold, check to see if the news pertains to this company alone. If it does, ignore it. If the news is not specific to the company, trade the more conservative position.
The strategy Figure 1 is a five-minute chart of the
If the market is poised to move, there will be significant pre-market volume in certain stocks. mini Dow futures. You can use any time interval — a one-minute, five-minute or 15-minute chart, etc. — as long as you can view the opening. This means the chart must be set up to reflect the opening and closing of the regular trading session, 9:30 a.m. to 4 p.m. ET (4:15 p.m. for stock index futures prices). Many traders are used to watching a separate chart of the continuous 24-hour futures session, but of course, opening gaps
the Dow gapped up 47 points as a result of a positive earnings report from Intel (INTC). On this day, pre-market volume was below 30,000. As a result, the appropriate trade is to immediately short the gap on the open using a full position size, as indicated in Table 2. To keep things simple, we’ll use nine contracts as a full position, which makes a two-thirds position six contracts and a one-third position three contracts.
FIGURE 1 THE OPENING GAP This 47-point-plus opening gap in the mini Dow futures was filled in the first hour of trading for a $235 per-contract profit. 9,830
Mini Dow futures (YM), five minute
9,820 Gap is filled for a 47-point gain, or $235 per contract (47 points x $5 per point).
9,810 9,800 9,790 9,780 9,770 9,760 9,750 9,740 9,730 9,720 9,710 10/15/03
11:00
12:00
13:00
14:00
15:00
9:00
9,700
10:00
Source: eSignal
won’t show up. Figure 1 shows the first day in a set of back-to-back earnings announcements that caused opposite reactions in the market. On the morning of Oct. 15, 2003,
ACTIVE TRADER • December 2004 • www.activetradermag.com
We will use a $100,000 account, which means we are trading one contract for each $11,100 in the account for a full position. Although you can trade a mini Dow or E-mini S&P contract with only a few 13
&
FUTURES
OPTIONS
Trading Strategies continued
FIGURE 2 THE DAY AFTER One day after the trade setup shown in Figure 1, the mini Dow contract opened lower, setting up a long trade. 9,800
Mini Dow futures (YM), five minute
9,790 Gap filled for a 61-point gain, or $305 per contract.
9,780 9,770 9,760 9,750 9,740 9,730 9,720 9,710 9,700
10/16/03 15:00 9:00 10:00 Source: eSignal
11:00
12:00
13:00
14:00
FIGURE 3 EMOTIONS TRIGGER GAP The E-mini S&P futures made a downside opening gap on Aug. 2, 2004, on terrorist threats. The market spent most of the day filling the gap. E-mini S&P 500 continuous contract (ES), five minute
1,106 1,105
Close on 7/30/04: 1,103.75
1,104 1,103 1,102 1,101 1,100 1,099 1,098 1,097
Open on 8/2/04: 1,097.00 14:45 15:0515:25 15:45
Source: TradeStation
14
8/2
1,096
10:00 10:2010:4011:00 11:20 11:4012:00 12:20 12:40 13:00 13:2013:40
thousand dollars, this trading plan controls risk by limiting exposure relative to the amount of available capital. Use a 1:1.5 reward/risk ratio (risking 1.5 points to make 1 point) for gap trades that are less than 40 mini Dow points or 4 E-mini S&P points. For gaps larger than these, use a 1:1 reward/risk ratio. In the case of Figure 1, we would risk 47 points to make 47 points. If the gap had been 30 points, we would risk 45 points. Some traders might question an approach that risks more than the potential profit. Most beginning traders are taught to use a 3:1 reward/risk ratio, risking 1 point to gain 3. They inevitably wonder why they are repeatedly stopped out just before the market turns. In general, wider stops produce more winning trades; the key is to trade only those setups with a better than 80percent chance of winning. The market sold off immediately after the bell, filling the opening gap within an hour. Ironically, the next day IBM came out with a disappointing earnings report, knocking the market down on the open. Figure 2 shows the resulting buy setup had just a small open loss at one point, although many traders might have been stopped out on the pullback around 11 a.m. ET. However, keep in mind the strategy is to maintain a reward/risk ratio of 1:1, not to tighten your stop when the market moves in your favor. If the stop had been hit, the loss would have been approximately $305 per contract ($2,745 for the nine-contract full position), not including slippage and commissions. This loss is reasonable because of the 80-percent success rate of the setup. Using a tighter initial stop or trailing stop would have turned this position into a losing trade or, at best, a breakeven trade. Using the risk parameters designed for this trade setup allowed the position to remain open until the gap was filled for a gain of 61 points. As a rule, using a trailing stop will negatively affect the gap trade’s win/loss ratio. When the trade is executed, the best thing a trader can do is to walk away and let the orders do their work. This is the difference between professionals and amateurs: Professionals won’t second-guess a
www.activetradermag.com • December 2004 • ACTIVE TRADER
trading methodology, while amateurs are constantly adjusting.
Ignore the reasons for the gap The size or cause of a gap has little impact on whether or not it will be filled. Figure 3 shows an example of emotions triggering an opening price gap when, on Aug. 2, the market gapped down on the open because the U.S. government issued a terror warning the previous day. There were rumors of a plan to blow up a large financial institution. However, after a choppy first half of the day, the market firmed, shorts got nervous and started covering, and the gap was filled by 1:30 p.m. ET for a 6.75-point S&P Emini profit ($337.50 per contract).
FIGURE 4 MULTIPLE GAPS The first opening gap on this chart — which remained unfilled for the next six days — set up a short trade that was stopped out for a loss. Subsequent opening gap trades were more successful. Mini Dow September futures (YMU04), 15 minute Gap of +62 points fills in 6 bars
Gap of -52 points fills in 9 bars
Short break of bear flag. Target is gap from 8/18
Gap of +13 points fills in 1 bar
9,500 9,480 9,460 9,440 9,420 9,400 9,380
Gap of +44 points fills in 9 bars
9,360 9,340 9,320
Relax and trade
9,300 Figure 4 shows a 15-minute chart of Gap on 8/18 of +44 points the September mini Dow futures fills on 8/25 9,280 (YMU04) with an opening gap on Aug. 18 that did not get filled for 8/18 13:15 8/19 11:45 14:15 8/20 12:45 8/21 13:45 8/22 12:15 8/25 13:15 8/26 six trading days. (Other opening gaps occurred before price eventuSource: TradeStation ally filled the first gap.) On this day, the mini Dow gapped up a modest profit ($2,295). All these gaps followed each type of trade setup. 44 points prior to the release of some light pre-market volume, so they were Gaps are the one moment of the tradeconomic numbers. The pre-market volexecuted with full positions. ing day where everyone has to show ume was modest, between 30,000 and On Aug. 22, 2003, Intel announced their poker hand, and this creates a big 70,000 shares for the key stocks, so the “cautious upside earnings revisions.” advantage for short-term traders. appropriate step was to short a two- The market exploded to the upside and Understanding the dynamics behind thirds-size position on the open. gapped right above key resistance. The opening gaps is paramount to trading The market rallied, sold off a little just trade was to short the 62-point gap with them successfully.Ý prior to the economic numbers, and then a full-size position. Six bars later, the tarshot higher once the numbers were get was hit for a 62-point profit, or $310 For information on the author see p. 10. released. Using the 1:1 reward/risk ratio per contract ($2,790). resulted in a 44-point stop. The market During the afternoon session, the marRelated Active Trader never retraced to the gap’s midpoint ket traced out a bear flag pattern. With level (where half the position could be the opening gap under the market still articles covered), and instead rallied right unfilled, the trade was to place a sell stop “Trading the overnight gap” by David through the stop, producing a loss of at 9,392 to let the trend of the market iniNassar, March 2001, p. 66 $220 per contract. For a two-thirds positiate the trade based on a breakdown of “Morning reversal strategy” by Bryan tion (six contracts) the loss was $1,320. the flag. The entry stop was filled and the C. Babcook and Arthur Agnelli, This move left an open gap below the risk point for the trade was above intraMay 2003, p. 36 market. The next day the market opened day resistance at 9,455. The target was the modestly lower, triggering a long trade Aug. 18 gap at 9,304. The market spent “Technical Tool Insight: Gaps,” April that resulted in a quick $65-per-contract the rest of the day trending lower, filling 2003, p. 82 profit ($585 total). The following day the the gap and resulting in an 88-point gain, “Technical Tool Insight: Islands,” market opened 52 points lower and or $440 per contract ($3,960). August 2002, p. 82 filled the gap a few hours later for a $260-per-contract profit ($2,340). The A brief window of opportunity You can purchase past articles online next day, the market gapped up 44 The market’s nature is to prevent as at www.activetradermag.com/ points, triggering a short trade that came many people as possible from consispurchase_articles.htm and download close to the stop-loss point, but eventual- tently making money, which is why it is them to your computer. ly filled the gap for a $255-per-contract crucial for a trader to follow rules for ACTIVE TRADER • December 2004 • www.activetradermag.com
15
FIGURE 1 EQUITY CURVE The frequency of down gaps increased after the broad market topped out in early 2000. The system exposure (light green area) increased substantially after this point. Note that many of these gaps are still open.
Gap closer
130,000 120,000
Markets: Any.
110,000 100,000
System concept: Most traders are familiar 90,000 with the technical analysis axiom, “All gaps are eventually closed.” A gap occurs when a 80,000 price bar’s high is lower than the previous low 70,000 or its low is higher than the previous high. A 60,000 significant gap creates a void in which no trades occur, as shown in Figure 1. An “open50,000 ing gap” occurs when price opens above the 40,000 previous high or below the previous low; such 3 0,000 gaps can be filled the same bar, in which case no visible bar-to-bar gap (such as the one in 20,000 Figure 1) will appear on the chart. 10,000 The idea that gaps are eventually closed stems from the absence of trades within the 0 3/3/93 range of the gap. Because there are no traders who are holding positions within the gap zone (some may have entered positions earlier in the chart’s history), there is an absence of the upside resistance that is typically caused by traders seeking to exit at breakeven or a profit-target level. Because of this lack of
1/7/94
1/3/95
1/2/96 Equity
1/2/97
1/4/99 Cash
1/3/00
1/2/01
1/2/02
1/2/03
Linear reg
resistance, price often moves sharply to close the gap when it first recovers and penetrates the gap zone. This type of price movement can also lead to the “island FIGURE 2 SAMPLE TRADES reversal” pattern, which occurs when a gap in one direction is followed by (after The system went long when Apple Computer gapped down more than 13 percent on one or more intervening bars) a gap in the June 19, 2002. Price started moving in the direction of closing the gap, but another opposite direction. down gap occurred on July 17, 2002, causing a new long position to be established. This test is designed to see if the axiom Apple Computer (AAPL), daily regarding closing gaps holds water. The 25.00 10 gaps, seven closed (70%) system tested here goes long the day after a large gap down and holds the position 24.00 until price reaches the low of the bar 23.00 immediately before the gap — i.e., when the gap is closed. 22.00 This “system” is for experimental pur21.00 poses only. The goal is to test the effectiveness of trading gaps in the simplest way 20.00 possible; no protective stops are included. 19.00 Because of this, positions can be held indefinitely and result in substantial draw18.00 downs when gaps are never closed. If you wanted to actually trade a gap-based sys17.00 tem, you would most likely use a protec16.00 tive stop to protect against these losses. Buy 15.00 14.00 Buy
Volume
20M
July 2002 Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)
16
August 2002
September 2002
Rules: 1. Enter long on the open the day after a down gap greater than the 20-bar average true range (ATR) is completed. 2. Place a limit order to sell the position at the low price of the bar that immediately preceded the gap. 3. The system will maintain multiple
www.activetradermag.com • May 2003 • ACTIVE TRADER
FIGURE 3 DRAWDOWN CURVE open long positions (see Figure 2). 4. Hold the position indefinitely until the gap is closed and the limit sell is triggered. Money management: Risk 9 percent of account equity per trade. This level was chosen because it was the largest position size that allowed all gaps to be traded during our test period. Starting equity: $100,000 ($10 slippage/commission deducted per trade).
0% -2% -4% -6% -8% -10% -12% -14% -16% -18% -20% -22% -24%
As more gaps were opened and more long positions established, a large drawdown began in 2000.
Test data: The system was tested on the Active Trader Standard Stock Portfolio, which contains 3/3/93 1/28/94 the following 18 stocks: Apple Computer (AAPL), Boeing (BA), Citibank (C), Caterpillar (CAT), Cisco (CSCO), Disney (DIS), General Motors (GM), Hewlett Packard (HPQ), International Business Machines (IBM), Intel (INTC), International Paper (IP), JPMorgan Chase (JPM), Coke (KO), Microsoft (MSFT), Sears (S), Starbucks (SBUX), AT&T (T) and Wal-Mart (WMT). Test period: January 1993 through January 2003. System results: A total of 62 gaps occurred during the 10-year test period. Of these, 50 (80 percent) were closed for a profit. The remaining 12 gaps were open at the end of the test period. The average profit for the closed gaps (which took, on averSTRATEGY SUMMARY Profitability Net profit ($): Net profit (%): Exposure (%): Profit factor: Payoff ratio: Recovery factor:
11,942 11.94 28.42 1.27 0.34 0.35
Drawdown Max. DD (%): Longest flat days:
-24.75 465
2/1/95
1/30/96
2/3/97
1/4/99
1/3/00
1/2/01
1/2/02
1/2/03
age, 100 trading days to close) was just under 11 percent. By comparison, the average loss of the 12 gaps that are still open is a sharp -32 percent, and the average number of trading days they have been open is about 350 (about one and a half years). That most of the gaps in the test portfolio within the past 10 years have been closed reinforces the idea that gaps do have a tendency to get filled — although it often takes a while. However, the damage done by the minority of gaps that did not close wiped out most of the profits achieved from the majority of gaps that did close. This leads to the conclusion that trading gaps on their own entails significant risk. However, it is possible to combine gaps with other trading tools and methods. The old saying, “All gaps are eventually closed,” may not be totally accurate, but knowing the odds are good that a certain price target will be reached can play an important role in a trading strategy.Ý
Trade statistics No. trades: 62 Win/loss (%): 80.65 Avg. gain/loss (%): 2.69 Avg. holding time: 148.15 Avg. profit (winners): 10.97 Avg. hold time (winners): 100.06
PERIODIC RETURNS
Avg. loss (losers) %:
-31.80
Weekly
0.03%
0.16
6.56% -12.50%
49.23%
9
17
Avg. hold time (losers): Max. consec. win/loss:
348.50 38/4
Monthly
0.15%
0.16
13.54% -9.68%
47.90%
5
6
Quarterly 0.43%
0.15
16.34% -14.11%
53.66%
3
3
Annually
0.22
10.73% -12.90%
60.00%
4
1
LEGEND: Net profit — profit at end of test period, less commission • Exposure — the area of the equity curve exposed to long or short positions, as opposed to cash • Profit factor — gross profit divided by gross loss • Payoff ratio — average profit of winning trades divided by average loss of losing trades • Recovery factor — net profit divided by max. drawdown • Max DD (%) — largest percentage decline in equity • Longest flat days — longest period, in days, the system is between two equity highs • No. trades — num ber of trades generated by the system • Win/Loss (%) — the percentage of trades that were profitable • Avg. profit — the average profit for all trades • Avg. hold time — the average holding period for all trades • Avg. profit (winners) — the average profit for winning trades • Avg. hold time (winners) — the average holding time for winning trades • Avg. loss (losers) — the average loss for losing trades • Avg. hold time (losers) — the average holding time for losing trades • Max. consec. win/loss — the maximum number of consecutive winning and losing trades
— Compiled by Dion Kurczek of Wealth-Lab Inc.
Avg. Sharpe Best Worst return ratio return return
1.60%
% Max. Max. Profitable consec. consec. periods profitable unprofitable
LEGEND: Avg. return — the average percentage for the period • Sharpe ratio — average return divided by standard deviation of returns (annualized) • Best return — best return for the period • Worst return — worst return for the period • % Profitable periods — the percentage of periods that were prof itable • Max. consec. profitable — the largest number of consecutive prof itable periods • Max. consec. unprofitable — the largest number of consec utive unprofitable periods Trading System Lab strategies are tested on a portfolio basis (unless otherwise noted) using Wealth-Lab Inc.’s testing platform. If you have a system you’d like to see tested, please send the trading and money-management rules to
[email protected].
Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not guarantee future results; historical testing may not reflect a system’s behavior in real-time trading.
ACTIVE TRADER • May 2003 • www.activetradermag.com
17
FUTURES
Trading System Lab FIGURE 1 PORTFOLIO EQUITY CURVE
Gap closer
The equity curve exhibits some volatility, but also an overall upward bias and extremely low market exposure. This is a result of the small number of trades, as well as their short holding periods.
Markets: Any.
System concept: The stock Trading System Lab (p. 54) featured an experimental system designed to trade gaps. The intention was to go long on every down gap and hold the position until the gap was closed (if it ever closed). This provides useful information about the dynamics of gap behavior. However, it is not possible to hold a losing futures position in a similar manner because the higher leverage in futures results in losses of a much larger magnitude. Taking this into account, the futures system goes long right when price is starting to fill a down gap. The absence of resistance in the price void of the gap should provide positive momentum for a long trade. Based on the results of the stock test, it is likely most of the gaps will be filled. In addition, this system uses three different exits to protect capital while giving trades room to breathe. The strategy uses a breakeven stop entered soon after the trade is profitable to protect against a reversal. When the gap is not filled and prices do not reach our breakeven level, we employ a wide stop-loss order. The system should have a large number of winning and breakeven trades, and a small number of large losses. Because of the high expected win-loss ratio, the strategy uses an aggressive maximum risk setting (10 percent equity loss per FIGURE 2 SAMPLE TRADES
200,000 190,000 180,000 170,000 160,000 150,000 140,000 130,000 120,000 110,000 100,000 90,000 80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 0
8/16/93
7/4/94
6/2/95
Equity
370.00
360.00
350.00
340.00
330.00
320.00
310.00
300.00
290.00
Volume 100,000
May 1999
June 1999
July 1999
Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)
18
August 1999
September 1999
4/1/97
3/2/98
Cash
1/3/00
1/2/01
1/2/02
Linear reg
trade). All traders must weigh these considerations and determine their personal risk tolerance when deciding on the stoploss and maximum risk levels.
Gaps in gold trigger two trades. The green lines represent the entry points and the red lines represent the profit-target exits. Notice how prices gapped up to close the first gap down, forming an island reversal. The second gap also closed, but not before the trade was stopped out. Increasing the stop-loss distance would have turned this trade into a winner. Gold futures (GC), daily
5/1/96
October 1999
Rules: 1. A long entry setup occurs when there is a down gap greater than the 20-bar average true range (ATR). Multiple open trades are acceptable. 2. Go long on a buy stop order at the high of the down-gap bar plus one tick. 3. Exit with a profit using a limit order at the low of the bar that preceded the down gap. 4. Place a stop-loss order below the entry price that is three times the distance between the entry price and the profit target level. Note: Wait until the close of the entry bar before placing the profit target and stoploss orders. 5. As soon as the contract closes with a gain of at least one percent, place a breakeven stop to exit at the entry price. Risk control and money management: 1. Starting equity: $100,000. Deduct $10 slippage/commission per contract (entry and exit). 2. The number of contracts to buy is determined by calculating the distance between the entry price and the initial stop-loss level. Buy the number of contracts that results in a maximum loss of 10 percent if the stop-loss is hit.
www.activetradermag.com • May 2003 • ACTIVE TRADER
FIGURE 3 DRAWDOWN CURVE Test data: The system was tested on the Active Trader Standard Futures Portfolio, which contains the following 20 futures: DAX30 (AX), corn (C), crude oil (CL), German bund (DT), Eurodollar (ED), Euro Forex (FX), gold (GC), copper (HG), Japanese yen (JY), coffee (KC), live cattle (LC), lean hogs (LH), Nasdaq 100 (ND), natural gas (NG), soybeans (S), sugar (SB), silver (SI), S&P 500 (SP) and10 year T-Notes (TY). Test period: This test used ratio-adjusted data (from Pinnacle Data Corp.) spanning August 1993 to November 2002.
0.00% -2.00% -4.00% -6.00% -8.00% -10.00% -12.00% -14.00% -16.00% -18.00% -20.00% -22.00% -24.00%
Test results: There were a total of 69 trades during the test period. This was less than the number of gaps that occurred, but because the system enters as price begins to penetrate the gap, there could be setups that have not triggered trades yet. Eleven of the trades triggered our breakeven stop and were closed at the breakeven level. Ten trades were losers, while 48 were winners. This confirms our expectation of the system’s win-loss behavior. Counting breakeven trades as losers, the system had a winloss ratio of nearly 70 percent. The average profit of winning
8/16/93
STRATEGY SUMMARY Profitability
Trade statistics
Net profit ($):
94,659
Net profit (%):
94.66
Exposure (%):
3.07
No. trades: Win/loss (%):
69 69.57
Avg. gain/loss (%):
0.96 16.62
Profit factor:
1.79
Avg. holding time:
Payoff ratio:
0.96
Avg. gain (winners) %:
2.54
Recovery factor:
2.08
Avg. hold time (winners):
8.96
Avg. loss (losers) %:
Drawdown Max. DD (%): Longest flat days:
-2.65%
-25.27
Avg. hold time (losers):
34.14
570
Max. consec. win/loss:
7/3
The largest drawdown, which began in late 1999, was eliminated in mid-2002. The system exhibits a favorable recovery factor (the net profit divided by the maximum drawdown) of 2.08.
LEGEND: Net profit — profit at end of test period, less commission • Exposure — the area of the equity curve exposed to long or short positions, as opposed to cash • Profit factor — gross profit divided by gross loss • Payoff ratio — average profit of winning trades divided by average loss of losing trades • Recovery factor — net profit divided by max. drawdown • Max DD (%) — largest percentage decline in equity • Longest flat days — longest period, in days, the system is between two equity highs • No. trades — num ber of trades generated by the system • Win/Loss (%) — the percentage of trades that were profitable • Avg. gain — the average profit for all trades • Avg. hold time — the average holding period for all trades • Avg. gain (winners) — the average profit for winning trades • Avg. hold time (winners) — the average holding time for winning trades • Avg. loss (losers) — the average loss for losing trades • Avg. hold time (losers) — the average holding time for losing trades • Max. consec. win/loss — the maximum number of consecutive winning and losing trades
7/5/94
6/6/95
5/3/96
4/4/97
3/5/98
1/3/00
1/2/01
1/2/02
trades was 2.54 percent, while the average loss of losing trades was -2.65 percent. Overall, these are very positive statistics, considering the degree to which the win-loss ratio is leaning toward the win column. The similar behavior of gaps in stocks and futures is interesting. By analyzing the behavior of gaps in one market we were able to design a profitable system based on the same phenomenon in a different market. The message of this strategy is that it is worthwhile to pay attention to gaps, especially when prices start to fill a gap. The lack of resistance in the gap area can be exploited if you can act quickly enough. — Compiled by Dion Kurczek and Volker Knapp of Wealth-Lab Inc.
PERIODIC RETURNS Avg. Sharpe Best Worst return ratio return return
% Max. Max. Profitable consec. consec. periods profitable unprofitable
Weekly
0.16%
0.50
15.91% -12.98%
24.28%
4
55
Monthly
0.70%
0.52
19.31% -12.98%
36.28%
4
13
Quarterly 2.05%
0.52
32.62% -12.16%
52.63%
4
4
Annually 10.21% 0.55
39.42% -12.75%
77.78%
6
2
LEGEND: Avg. return — the average percentage for the period • Sharpe ratio — average return divided by standard deviation of returns (annualized) • Best return — best return for the period • Worst return — worst return for the period • % Profitable periods — the percentage of periods that were profitable • Max. consec. profitable — the largest number of consecutive profitable periods • Max. consec. unprofitable — the largest number of consecutive unprofitable periods Trading System Lab strategies are tested on a portfolio basis (unless otherwise noted) using Wealth-Lab Inc.’s testing platform. If you have a system you’d like to see tested, please send the trading and money-management rules to
[email protected].
Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not guarantee future results; historical testing may not reflect a system’s behavior in real-time trading.
ACTIVE TRADER • May 2003 • www.activetradermag.com
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