I was recently a speaker in Austin Texas to a group of traders.
Jack Bouroudian was speaking there too. I had my laptop open with TradeStation running live. It was a few hours into the trading day and Jack asked me if the market (S&P 500) had closed the opening gap (it had).
He had several hundred contracts on a trade that the market would close the opening gap. I asked him about that strategy and he indicated that it was a high probability trade that he had done many times in his many years of trading.
In his book "Mastering the Trade" John Carter titles chapter 6: "THE OPENING GAP: THE FIRST AND HIGHEST PROBABILITY PLAY OF THE DAY".
On the other hand; I have an automated trading strategy that takes the other side of that trade and works well.
Depending on the details, you can make good trades on either side of the gap play.
The following data was collected using 10 years of price information on the S&P 500:
Market = Futures (this can be done with ETFs as well)
Contract = ES
StopLoss = $500/contract
Open the trade 3 minutes after the market opens
End the trade when the gap is filled, you are stopped out, or 60 minutes has elapsed (unless otherwise noted)
Market gaps DOWN 4-8 points:
Gap Down: 284 gaps
102 filled gaps (35.9%) after 60 minutes
150 filled gaps (37.3%) by the end of the day
188 gaps (66.2%) were filled with no time limit ($500 stoploss still in place)
-With a $650 stoploss the winners rise to 194 (68.5%). 68.5% winners sounds good but
there are long periods when it does not work (Feb 2001 - May 2002, & April 2006 - Dec 2007).
Market gaps UP 4-8 points:
Gap Up: 315 gaps
135 filled gaps (42.9%) after 60 minutes
194 filled gaps (61.6%) by the end of the day
209 gaps (66.6%) were filled with no time limit ($500 stoploss still in place)
-With a $650 stoploss the winners rise to 220 (70.1%). 70.1% winners sounds good and is good.
Market gaps DOWN 8 or more points:
Gap Down: 263 gaps
55 filled gaps (20.9%) after 60 minutes
98 filled gaps (52.8%) by the end of the day
117 gaps (44.5%) were filled with no time limit ($500 stoploss still in place)
-With a $650 stoploss the winners rise to 130 (49.4%)
Market gaps UP 8 or more points:
Gap UP: 225 gaps
50 filled gaps (22.2%) after 60 minutes
86 filled gaps (38.2%) by the end of the day
118 gaps (52.4%) were filled with no time limit ($500 stoploss still in place)
-With a $650 stoploss the winners rise to 130 (57.7%)
Market gaps of less than 4 points generally widen and hit the stoploss before they close the gap.
-The risk-reward is too low (less than $200 profit for a risk of at least $500 stoploss)
From the above statistics, moderate gaps are the most likely to be filled and a gap up is better than a gap down.
The best parameters to use on ES are:
Best gap up range (short trades): 5.5 to 10.75
Best gap down range (long trades): -5.25 to -8.25
John Carter's book has a number of his guidelines on gap trades that are worth reading. One item is worth special mention:
If you enter a gap trade with two contracts of ES or a double load of stocks, then exit half of your position when the gap is HALF filled. 77% of the time you will make a profit on that first tranche. For the remainder of the position you can use the Falcon Standard Exit methods, exit after 2.7 hrs if the gap has not been filled, or some exit method that you like best. After you sell the first tranche then don't allow the remainder of the position to go so far against you that you take a loss on the overall trade. I prefer to do no worse than a break-even exit on the remainder of the position (The first exit locks in a profit).
Also, try to wait until the momentum begins to shift in your direction before entering the trade. That should get you at least one extra point on the trade.
