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.
It is very similar to the morning range breakout that we discussed but it is a gap and there are different factors driving the setup. The concept of filling a gap is almost a self-fulfilling prophecy as traders are trained to believe this will occur with a high probability. Additionally, this day tradingstrategy works especially well on large cap stocks as they accumulate larger levels of interest through institutional program trading. They are also more liquid and have tighter bid/ask spreads which enable minimal slippage, especially on thousands of shares. For fair disclosure, this is not one of my favorite setups. I do not like trading against the trend, it makes trading a bit more difficult in my opinion.
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.
The basic stop loss rule when day trading gaps is to put the order below the reversal bar. However, this practice does not provide a clearly stated stop loss range. The reason for this is that there are different reversal candle patterns, with different sizes.
Imagine the price fulfills 70% of a bullish gap and then a hammer reversal candle is formed. Hammer candles have a very long lower candle wick. This would trigger a stop that is pretty far from our entry price.
Now, imagine the reversal candle is not a hammer, but an inverted hammer. Inverted hammers have very small lower candlewicks. This means that when we put the stop below that wick, it will be relatively close to our entry price. This setup would allow us to maintain a relatively low risk-to-return ratio
Doji reversal candles also allow tight stop loss positioning. There are doji candles, which have small candle wicks. However, there are also doji candles with bigger candle wicks like the dragonfly doji reversal candle.
I have worked out a simple risk management rule for day trading gaps, by conforming to the size of the reversal candle. However, never risk more than 1% of your bankroll in a morning gap reversal trade. If you have a hammer reversal candle, place your stop as low as possible, but do not go below 1%.
Intraday Gap Trading Strategies for Morning Reversal Fill
Trading a Gap Fill with a slow mover
Above you see the 5-minute chart of Bank of America from Aug 25, 2015. The image displays a short trade on a morning reversal gap fill.
The new trading day starts with a sizeable 5.61% bullish gap. This gap size fits in our 3% - 7% gap size requirement. Notice that the first 5-minute candle after the gap is a hanging man reversal candlestick. This gives us a short signal to trade the eventual gap fill scenario. However, we wait to see if BAC will develop a range.
This does not happen.
The next candle is bearish and relatively big. For this reason, it was highly unlikely for BAC to create a range. Therefore, we short BAC at $16.07 per share.
We put our stop loss right above the head of the hanging man candle pattern as shown on the image above. This means that we are risking 0.87% of our capital in this trade. The risk percentage fits our requirement of less than 1%, giving us a great setup for our short position.
BAC decreases to the psychological level of $15.90 per share. This is when BAC actually begins to trade in a range. The range plays out for two hours.
However, we are patient and stay with our trade. The price continues declining, breaking its previous low. The drop reaches the level at 15.75.
This is when the price enters a second trading range. This trading range plays out for 1 hour and 20 minutes.
After this consolidation phase, BAC begins another leg down.
This price drop takes BAC to our target area of $15.30, minutes before market close.
Let’s summarize the trade action:
- BAC opened with a 5.61% bullish gap.
- The first candle for the day on the 5-minute chart is a hanging man reversal candle pattern.
- We wait for a range to develop.
- We short BAC at $16.07 per share.
- We place a stop loss right above the head of the hanging nan reversal candle.
- The risk we take with our stop loss equals 0.87%, which fits our 1.00% maximum rule.
- The price hits our target at $15.29 per share.
- We profit 4.83% on the size of our trade while risking 0.87%.
- This is a 1:5.5 risk-to-return ratio.
This is an example of a successful morning reversal gap fill trade. Notice that the consolidation we anticipated came later than expected. We were already in the trade and we had to sit patiently through the entire consolidation period which lasted two hours.
Extending the Target of the Morning Gap Fill
The case below will show you how the price of the equity fills the gap relatively fast. A quick fill presents the opportunity to extend our usual target since the market momentum is in our favor.
Have a look at the image below:
Above you see the 5-minute chart of Yahoo Inc. from Jan 28, 2016.
Yahoo starts out with a 3.03% bullish gap, followed by a hanging man reversal candle. This gives us a signal that the bullish gap could turn into a counter trade opportunity.
Notice that the trading volumes in the time of the gap are relatively high. This implies that a range is not likely to develop. Therefore, we short the stock based on the signal attained from the hanging man reversal candlestick. We place a stop loss order right above the head of the hanging man candle, which represents a trade risk of .49%.
The next two candles are bearish and are relatively large in size. The second candlestick completes our morning reversal gap fill target (green horizontal line). According to our tight strategy rule, we have to close our trade here. If we do so, we would collect a profit equal of 2.5%.
However, we observe the expanse in price action in the bearish direction, therefore we hold to our guns.
The next candle in the row is bullish and small. We can use the area above that candle to adjust our stop.
The point is to try catching a further bearish move, while locking in some guaranteed profit. Fortunately, the decrease continues with another bigger bearish candle. On the way down we see a hammer reversal candle, which alarms that the downtrend might be ending soon.
We adjust the stop again. This time, we put the stop right above the body of this candle. Notice that I say above the body and not the upper candlewick. The reason for this is that if the next candle breaks the body of the previous candle, we will confirm the reversal pattern.
However, the price continues with the decrease without even getting close to our stop. Four more bearish candles appear on the chart, dropping Yahoo to $28.95 per share. Notice that since the market opened there were 10 candles on the chart. Nine of them are bearish and only one is bullish.
This is why we have the confidence to stay in the trade!
After reaching 28.95, YHOO enters a trading range. Therefore, we move our stop above this resistance area as shown in the image above. Five candles after the price enters the ranging move our stop loss is triggered.
Our trade is closed at $29.16 per share. During this bearish position we manage to net a profit of $1.34 per share.
Let’s now summarize all the data.
- YHOO opened with a 3.03% bullish gap.
- The first candle of the day on the 5-minute chart was a hanging man reversal candle pattern.
- Volumes are relatively high and bearish, which implies that a range is not likely to develop.
- We short the YHOO stock at $30.49 per share.
- We put a stop loss right above the head of the hanging man reversal candle.
- The risk we take with our stop loss is 0.49%, which fits our 1.00% maximum rule.
- After 10 minutes the price hits our target at $29.69 per share.
- We decide to hold the trade because of the higher volumes and rapid price development.
- We use regular price action rules for adjusting our stop loss on the way down.
- Our assumptions turn out to be correct, since the stock experienced 9 bearish candles out of 10.
- The next price hesitation crosses a crucial resistance area and we close at $29.16 per share.
- We generate 4.40% profit with an initial risk of 0.49%.
- This results in a risk-to-return ratio of 1:9
- Morning Reversal Gap Fill represents a shift in the market momentum, which results in a direction change.
- When you trade Reversal Gap Fill, try spotting gaps between 3% and 7%.
- Do not attempt to trade bigger gaps, since the price in these cases end up ranging.
- This setup works best when the gap is opposite to the general price trend.
- Enter the market on a reversal candle after the gap.
- Always put a stop loss above the reversal candle on a bullish gap and below the reversal candle on a bearish gap.
- Make sure your stop loss covers a maximum loss of 1% no matter of the candle size.
When you trade shorter time frames on high trading volumes you can always adjust your stop loss in order to lock in guaranteed profit.