Gap Pullback Buy

by webmaster on June 13, 2011

Our next strategy, the gap pullback buy, is one of my favorite setups.  It allows us to let the morning action play out and enter into a trade with a strong setup and relatively low amounts of risk.

Trading Characteristics of a Gap Pullback Buy

The gap pullback buy is predicated on the concept that the majority of the traders who will chase a gap will do it on the open with market orders. The rest of the novice traders who don’t chase the open will eventually get greedy and buy in over the next few 5 minute bars, albeit, with lower volume. Once this early morning interest fizzles out, the stock will begin to fall. Obviously, not all gaps will be retraced but if this day trading opportunity presents itself, we will be prepared with a plan.

Volume is key to this strategy and it is important to note that we want to see the stock open on huge volume followed by a further advance of 1 to 3 bars on lighter volume. It is in this light volume advance where we will see the lack of leadership and the precursor to a move lower. At this point we do nothing, except for observe the volume behavior. We are not attempting to pick a top and go short.

Gap Pullback Illustration

Once the stock makes its eventual short term top, we want to see it move lower on decreasing volume and partially close the gap before putting in a strong reversal bar, a hammer candlestick would be perfect here.  Traders should look for a strong pickup in volume on the reversal bar before taking a long position on the next bar. To increase the odds of a successful trade, the signal bar should close above the open of the session and stay above the close of the previous session. This will provide more indication that the stocks gap is for real. A buy stop order would be helpful here as traders can buy above the high of the reversal bar if price continues to move higher.

The presence of heavy volume and a strong reversal suggest that the big money is supporting this stock. This is exactly what we want to see as traders who are looking to follow the money.

Money Management

The rules for taking this trade and stopping it out are fairly simple. A long position should only be taken when price penetrates above the high of the reversal bar. A stop loss order should immediately be placed below the low of that bar and if the range of the bar is too large, move your position size down so that you are able to trade the setup the way it was intended to be traded. One of my personal rules is to set my stop to breakeven the second I am up 1% on the position. It is absolutely unacceptable as a day trader to be up on a trade by a significant amount and end up taking a loss on it.

As far as upside is concerned, the first bigger target is the high of the day where I will sell at least half, if not all of the position. However, always stay abreast of the market condition and the other support and resistance areas on the chart. If there are significant levels of resistance on the path to the HOD, I will not think twice about selling some of my position. Remember, this game is a marathon, not a sprint. Your goal should be to take small, consistent profits from the market rather than lottery money. This is not a dreamer’s game. The worst mistake a trader can make is to get attached to targets without tying in the context of the overall market; be nimble and be ready to change at any time.

The gap pullback sell is the opposite of this pattern.  It occurs after a gap down on the open followed by a retracement into that gap and a subsequent failure. You can basically turn our chart from above, upside down, to get an idea of how this day trading setup would look.

 

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