The morning reversal gap fill is another great trading setup for the first hour of trading, preferably within the first 20 to 30 minutes of trading. This strategy is a play on a shift in market momentum and is directly tied to market manipulation by the market maker on the open. As we discussed in our introduction to morning gaps, the market maker can legally manipulate the opening price of a stock and a reversal can occur under the right circumstances.
In addition to looking for stocks with heavy volume, I like to limit these trading candidates to ones that exhibit a 3% to 7% gap on the open. Once you start seeing large trading gaps (ie. Over 10%), stocks tend to get stuck in a sideways trading range for the rest of the day. These stocks are typically down heavy on news related items, for which no one is willing to dedicate too much capital to. Before we get into the setup, I strongly recommend that traders follow these two rules: 1) Remember we talked about watching the general market to make sure that all boats were sailing in the same direction? It is essential that the broad market is moving in the anticipated direction of your trade or getting ready to do so. This will dramatically increase the odds of this trade working out. 2) This setup will work best when the stock gaps in the opposite direction of the primary trend. It has better odds of filling the gap if there is generally a strong bias to the upside. Now that we have that out of the way, let's take a look at the setup. Look for a short term range to set up after the gap. I like to see this range take no more than 30 minutes to develop. Take a look at our example below. This is a great example because it illustrates the principle of agility and discipline. Notice the range that develops on the Bank of America (BAC) chart. It is gaps lower after being in an uptrend (not shown on chart) and creates a very nice looking hammer on the opening bar. It then moves sideways mimicking a bull flag, indicating that there is strength before challenging the 7.40 area. While we don’t have the time and salesdata available at this point, we can assume that the volume wasn’t terribly heavy on the sixth bar which broke resistance. It broke through it but did not accelerate. A trader that bought the breakout (as referenced by #1 in the chart) would have quickly seen that the trade reversed and should have been stopped out slightly below the breakout area. However, there was another chance to re-enter the trade, this time under better circumstances. On the next bar (referenced as #2), notice the big pickup in volume and the acceleration in price to blow out the resistance area. Now, this time, the trader would have been better served by waiting for the high of the previous bar to be cleared rather than the initial resistance. Notice how the stock moved higher in an explosive fashion on that bar and got close to filling the gap. The first thing that any trader should have done is move their stop up to at least breakeven, if not breakeven plus commission. Secondly, a volume spike of some sort came in near the area where the gap was. This was a potential trigger to sell a portion of their overall position.
As far as upside targets go, be flexible. The obvious target is for the stock to fill the gap; however, if it gets 80% there and puts in a nasty candlestick reversal pattern, do not be afraid to take your profits. I like to add the 10 EMA and 20 EMA as many traders are keeping an eye on these moving averages. These can help identify shifts in momentum and trend changes. Again, they are a guide, not an absolute.