I have written before about the many types of GAPS and I have mentioned the fact that opening gaps are very common while true gaps are very rare. I have also mentioned that there may be a legitimate strategy of just playing opening gaps. This has sparked many questions about the actual details of the strategy so I thought it worth the time to detail the actual playing of opening gaps.

Now to refresh and bring every one to the same spot; True Gaps are holes left in the trading pattern where no trading occurred from one day to the next.

There are in fact many types of gaps and gap patterns, but today we will focus on just the morning / opening gap. In other words, the stock or market opens up higher or lower than the previous day's closing price. This play will require you to be there watching the market open but only for a few minutes to an hour.

The common tendency is for the stock to gap open and make a short lived move in the direction of the gap before reversing and heading back to fill. So your set up must allow for the market to react to the opening price.

Candidates:

Some stocks will gap and then move on up and wait for a while before filling. These are not the targets for this strategy because we are looking for the plays that fill quickly. Our target gaps are actions where the stock gapped against the market to take advantage of order imbalances or aftermarket oddities. These plays are like a breakfast snack to start the day for Market Makers / specialists and savvy traders. We are looking for sizable gaps that begin to falter quickly.

Set Up: (we will use an upside gap, downside gaps are traded in reverse)

Ok, the first step after finding the target is to set the parameters of the play. The opening price is key. The difference between the opening price and yesterdays close is your profit target. It has to be big enough to justify the trade. Next, if it is a gap up then you will watch for a follow through to the upside. This does not usually last for very long, often just a few minutes.

Once it stalls and begins to reverse directions you mark the high point.

Now you have all the data points you need to play. You enter the trade as soon as it crosses the opening price going down and then place your stop at the high point of the day.

Now the particular vehicle you use to trade is up to you but I would be careful about the option selection process. You need to know how to select the right strike and month and whether to buy or sell premium. The X Factor Options Graphing tool is the best way to make that decision. Most people, who do this play, trade the stock only. It nails a 1 for 1 move and is a not subject to option price manipulation which often happens in volatile situations. Options can work but are not a simple explanation here. Besides if you can play the stock, it is a very short term trade and if you leverage 1000 shares and pick up $ .35, that $350 for breakfast. Not bad?

Now you set a babysitter stop so you do not have to monitor the trade all day.

The target is the fill of the gap which can come two ways. The simple and best way is a complete reversal to the previous closing price. You have your trailing stop waiting to capture the profit. However the gap may be a pricing trick / exercise (common) or it may be the real thing (rare). If is the real thing, it will not fill. The safety switch here is to move your stop down if the stock hesitates after the initial entry drop.

Now you have a neutral exit strategy and you do not have to monitor it any more. As I said it will require you to watch the beginning of the market action but not stay there all morning. The orders can be placed as contingent day orders allowing you to leave now. Wait, finish the article?

Review; the opening gap has to be big enough to warrant a trade. The triggers are the opening price and the first reversal point. If the first move up to the reversal point is quick, set your order. Enter as it drops through the opening price, then set a trailing stop just above the fill and set an exit stop in case it trades back up through your entry point. This version is for gaps where the previous day had little or no upside tail or price extension (high of the day).

Now a variation that you must be aware of? reaching down to the upside tail of the previous day is also a target and considered a fill. If there is an upside tail on the previous day's candle pattern (the high of the day), you must be prepared for the fill to stop there. This is fairly common so you may want to place your trailing stop there.

If the movement continues on down you continue to capture profits with the trailing stop. If it bounces you get a chunk of it and that's fine too.

Because gaps happen so often and to so many stocks there can be multiple targets every morning. Knowing the price history or rather the gap tendency can be a real advantage. Collecting a list of stocks that fit your criteria and scanning them each morning at the open could be like finding little presents at your doorstop each morning.

As in all my training advice, practice this many times before you start funding trades. It will not cost you to practice properly but it will cost you to play unprepared.

Please come to one of the Trader's Forge training sessions coming to Chicago and Washington DC in the coming weeks. I will train you to Bracket Trade and read charts and trade options better than ever. You will come away with skill, not just knowledge and information. Hope to see you there.

By Ryan Litchfield