Trading Gaps Properly

When looking for low risk opportunities, one situation that’s not as common in the futures market as it is with stocks is the formation of gaps. The reason stocks tend to gap more frequently is simply because they spend more time closed than trading with lots of activity. This exposes stocks to all types of gap risk such as market risk, or news related to the individual company. Alternatively, because futures trade continuously twenty four hours a day, roughly five and a half days a week, most gaps are created on Sunday at the open, and even then gaps are rare. It’s not like there’s a gap open every Sunday throughout the futures markets. Even more unusual are gaps formed in the middle of the week during earnings seasons. More on these later.

Because gaps are so uncommon, when they do occur they can produce high probability opportunities . Since our main focus is finding price levels were the forces of supply and demand are most out of balance what better example of that than a gap opening. Let’s think about how a gap occurs. In the chart below, note that the closing price of the December 2014 Australian Dollar futures contract on Friday was .8769, and on the following chart the opening price for Sunday was .8734. This left a price gap of 34 ticks.

First, the simple fact is that when all the orders started to come in Sunday afternoon there were an abundance of sell orders hitting the tape, and since those orders have to be matched with buy orders the nearest buyer came 34 ticks lower at .8734. The reason that compelled so many to sell is irrelevant, and yes , you can find out why but that won’t assist in finding a high quality trade. What’s most important here is that the creation of this gap represents the best picture of an imbalance of supply and demand. In this case, it is a supply imbalance. This suggests that there might be additional sell orders remaining to be filled.

As I mentioned earlier, the rarest of gaps are formed in the middle of the week. These typically form during reporting season for stocks. They occur because the stock index futures close for a very short period (15 minutes ) every week day between 4:15 and 4:30 EST. This is when the day session ends and the overnight session begins. One such gap occurred on October 28. On that day two major components of the Nasdaq 100 index (Twitter and Facebook) reported disappointing earnings. Commonly, companies that report their earnings after the closing bell usually release their results a few minutes after the close, producing a spike in price in the Futures market. In this instance however, both companies earnings hit the tape during the small window when the stock index futures were closed. The after-hours selling in these two stocks is what created this gap in the Nasdaq futures.

As we can see on the charts, this presented a low risk high probability shorting opportunity.

To trade gaps properly, the odds enhancers, such as structure of the level, first retracement and so on, have to score high in order to enable a high quality opportunity.

All told, gaps represent a big order imbalance, and as such we must always be on high alert when they happen. There is one caveat though, not every gap is tradable. This has to do with where the gap was formed in terms of the location of the move. In other words, was the gap created in the late stages of a move, or near a reversal of the trend? This is key information before taking the trade. This a good starting point in understanding gaps, and I hope this was helpful.

Until next time, good trading.

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Source:: Trading Gaps Properly