Background
The opening gap trading setup relies on a large price gap when the market opens for the day and a retrace of
price into that gap. Research shows that at least half the gap fills 81% of the time. With careful use of entry and
exit prices, this is a reliable trading setup, but you should change it to suit your taste and markets.
Methodology
The following figure shows the ideal opening gap trading setup. The vertical line separates the first day
from the second on a 5-minute chart. At candle B, price gaps open higher than candle A which ended trading the prior day. Price may or may not continue
trending upward. If it does, then it’s best that the move up is a strong one, without consolidation regions, candles with small shadows, and little price overlap between bodies.
In this example, price reverses at candle B by forming a tall upper shadow. This is a hint that the bears have begun shorting the stock after realizing that it is overbought. The next candle, C, confirms this when it fails to make a new high and the body is black. Use this candle as the signal candle, meaning place an order to short the stock a penny or two below the candle’s low. The order executes at candle D. Immediately place a stop above the high at candle C (or keep the stop order in your head). If price reverses on you, the stop will cover you.
As price drops, lower the stop but don't keep it too close. When price passes the 38% retrace of the AB move, switch
to the 1-minute scale and lower the stop to a penny or two above the high of the prior candle. Move the stop as each
new candle forms (using a penny above the prior candle’s high as the new stop price). I show the 50% target
as a horizontal green line, so let’s assume this is on the 1-minute chart.
Here, price closes lower at candle F but both E and F are small candles. That means indecision: The bulls and bears are fighting it out to determine direction. The tall lower shadow on candle E suggests that price is about
to reverse. At candle F, lower the stop to a penny or two above candle E. When candle F completes, lower the stop again to the position shown (a penny or two above the high at F). Candle G gets you out of the stock by tripping the stop.
Checklist
- Find candidates using the Nasdaq-100 heatmap for premarket trading. The page shows a square of stocks, arranged
by how much they have moved premarket and coded by color. Hovering your mouse on a square gives details about
the stock and if you click on a square, more information appears. Here is the link:
http://screening.nasdaq.com/heatmaps/heatmap_pmi.asp
- Use the 5-minute chart for entry, the 1 or 2 minute chart to time the exit
- Look for a large price gap from the prior day
- For profit potential, measure from the prior day’s low to the trend high today then take half of this
- If price continues moving up after the gap, look for few or no consolidation regions, and tall candles with short shadows
- When a candle color change occurs and price fails to make a new high, place an order to short a penny or two below the candle’s low
- Place a stop a penny or two above the candle’s high
- Follow price down, lowering the stop as appropriate. Use the middle of especially tall candle bodies as the stop location or a few pennies above the high of short candles. If the candles have tall shadows, then place the stop two candles back
- When price retraces the prior up move by 38%, then switch to the 1 or 2 minute chart to time the exit
- Use the prior candle’s high as the stop location
- Lower the stop as price drops until it takes you out
Research
I looked at 101 stocks during July 2007 and found the following.
- 59 stocks had price gaps that remained open throughout the day
- 42 stocks closed the gap sometime during the day
Looking at the 59 stocks with gaps remaining open, I found the following.
- 20 retraced less than 38% of the prior up move
- 15 retraced half way
- 24 covered more than 62% of the prior up move but did not close the gap
If you include the 42 stocks that closed the gap during the day, then 81% retraced at least half of the prior up move!
Example
The chart shows an example of the opening gap setup on the 5-minute scale for Dupont. Price closes
the prior day at A and gaps upward to candle B. Candle C is the signal candle, one that changes color. Even though
price makes a higher high on this candle, a short a penny below the lowest low would work well.
Entry is at 47.63
with a stop of 47.90, a penny above the high. Since the stop is far away from the low, once into the trade lower
the stop to a closer point.
Price makes a strong move down at candle D, piercing the 50% retrace of the AB move. The low at A is 46.57 and
the high at C is 48, for a midway target of 47.29. Since candle D bottoms at 47, switch to the 1-minute scale as
price nears the target (see next chart).
This is Dupont on the 1-minute scale. The target is 47.29, so if you switched to the 1-minute scale any time after
candle B, you could have used a penny above the top of the prior candle as the stop price. This method would have
taken you out of the trade at candle A, which has a high price of 47.39. This trade would have made 47.63 - 47.39
or 24 cents a share.
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