This is an introduction to the opening gap strategy. The first in a series of articles about automated trading strategies and systems.
Trading is about playing the odds and statistical probabilities. The opening gap trading strategy is based on statistical probabilities and therefore lends itself very well to automated trading.
What is the opening gap?
An opening gap is formed when the daily opening price of an instrument (stock or future) is significantly higher, or lower, that the closing price from the previous day.
The difference in price between todays’ open and yesterdays’ close is due to after hours and pre-market trading activity. Events such as news or company results that causes after hours price to move significantly can create a gap.
An opening gap creates a trading opportunity based on sound statistical probabilities.
What is gap fill?
Gap fill occurs when price moves to fill in the empty space in the gap. It is a statistical fact that gaps will always be filled.
For example, if todays opening price is higher than yesterdays closing price, then gap fill will occur when price falls back to yesterdays closing price. The gap is filled and no longer exists.
Although we know that a gap must always be filled, we cannot predict when that will happen. It may be today, or at any time in the future, depending on the dynamics of the market.
Research has shown that the size of the opening gap can play a role in the probability of the gap being closed that trading day.
In general, 70% of opening gaps are filled on the same trading day so they present excellent opportunities for day traders.
This figure represents gaps fills for all sizes of opening gaps, some of which will be too small to trade profitably, so the percentage of gap fills from tradable gap sizes is probably nearer 50%.
Although there is a definite mathematical edge to trading the opening gap, there is no certainty in this strategy at all so it is vital that you protect your position with strategically placed stop losses.
Pulling it all together
You can see the opening gap strategy in action in the image above (click image to enlarge). The instrument was oil futures (symbol CL), October 2009 contracts using a 5 minute chart.
A large gap up was created which filled soon after market opened.
Fading the opening gap (trading against it) with a short limit order and a profit target of gap fill produced a profitable trade with a higher degree of probability.
In our next article, we will discuss how opening gaps present good opportunities for automated system trading.