The Opening Gap: The Perfect Setup?

Trading is a lot like flying a helicopter in combat. The stakes are high and the risks are everywhere. The enemy can shoot you down, the aircraft can malfunction, or you can simply crash and burn on your own. 

As a “butter-bar” (2nd) lieutenant fresh out of West Point, I learned how to fly from the best of the best at the US Army Aviation Center in Fort Rucker, Alabama. I’ll never forget the words of my first instructor, a crusty old Vietnam veteran with a big southern drawl, “I’ll teach everything you need to know to fly that helicopter, but whether you survive or not is totally up to you.” Believe me; he was not talking about whether I’d graduate from the program. Up to that point, it had never crossed my mind that the world’s greatest instruction was no guarantee for my survival.

When I started trading, the parallels between learning how to fly and learning how to trade were striking. The keys to success were threefold: 1) Master the fundamentals, 2) Start slow, and 3) Above all else, survive the learning curve. So, I enrolled in a rigorous, monthly training program with a credible trading and options mentor.

Though I followed his system and rules precisely, I struggled with consistency. Because his approach was completely indicator-based and heavily reliant upon options, it was impossible to backtest, and therefore, I never knew if any given loss was due to my execution (i.e. interpretation of the charts) or was simply an unavoidable loser. (Using the flying analogy, it was sort of like having an accident and not knowing whether the cause was pilot error or an engine malfunction.)

Further, having significant sums of capital at risk in volatile stocks for weeks or more at a time was driving me crazy and making me sleep a little lighter than I liked. Just like a newbie pilot-in-training, I kept “over-controlling” by tinkering with my trades (i.e. cutting the winners short) in an attempt to reduce risk and lock in profits. This, of course, resulted in the classic beginning trader’s diet: “Eating like a mouse and defecating like an elephant.”

After a year and a half, it was clear that this proven, but highly subjective methodology was a terrible fit for me. I knew how to “fly,” but I needed to find an “aircraft” better suited for my personality. So I went looking for a style and approach that would work for my strengths (disciplined and mathematically inclined), my weaknesses (impatient and limited daytrading experience), and desired lifestyle (flexibility during the day without having to watch screens all day—I didn’t want another “job.”). Ultimately, this led me to the world of gap trading, and specifically fading the opening gap of the US equity indices such as the S&P 500, Dow 30, NASDAQ 100, and Russell 2000.

Why I Love Trading Gaps

Trading gaps may not be for everyone. But for me, I consider fading (i.e. Trading in the opposite direction) the opening gap, the ideal trade setup. Here’s why:

1) Gaps have an inherent directional bias and edge. Over 70% of all gaps in the US indices have filled the same day over the past ten years.

2) They occur daily. I am not reliant upon catching that "one big winner" to achieve my monthly or yearly goals.

3) They offer plenty of profit opportunity. In fact, the best move of the entire day often occurs right after the opening bell.

4) I can prepare in about 15 minutes before the market opens. No need to scan hundreds of stocks at night.  

5) It's an easy trade to learn and play. No need to "time" the entry—just use a market order at the open and trade in the opposite direction of the opening gap.

6) “Fire and forget.” The targets and stops are pre-defined, so I don't have to manage the trade after placing it.

7) Minimal slippage. Getting orders filled at my desired price is not an issue due to the highly liquid nature of the equity indices. 

8) My risks are controlled and limited. Plus, the trade is often over in an hour or two, so there is no overnight risk.

9) Gap trades work in bull and bear markets equally well. I don't need to predict the market’s next move.

10) Understanding the bias of the market after the open provides a trading edge for the rest of the day. This edge is helpful for optimizing my entries on swing and position trades.

If you are looking to improve as a trader, there are two critical questions that you must answer; 1) “What is my primary trade setup?” and 2) “What is my edge?” For me, the answer to the first question is the opening gap. My edge?  Historical probabilities. I’ll discuss this unique and compelling advantage in my next article.

Good trading and good gapping!

By Scott Andrews of MasterTheGap.com