A picture is worth a thousand words and nothing will wake you up quite like a morning gap!
The gap has the amazing ability of taking the breath right out of swing traders and long-term investors as they scramble to assess the pre-market and early morning trading activity.
In this article, we will discuss how to trade morning gaps on the open and how to take advantage of these chaotic situations.
Morning Gap Definition
The morning gap is one of the most profitable patterns that many professional day traders use to make a bulk of their daily trading profits. The morning gap occurs as a result of the build up in trading activity that occurs overnight due to a economic number, earnings release or company specific news event.
Day Trading Morning Gaps
With the advent of pre-market trading and the ECN’s, trading during non standard market hours has become much more accessible to the public investor; however, this is not to say that the market maker for each security is still not in control. Market makers are ultimately responsible for creating the market in these securities when there is no bid or ask available and the market can be dramatically shifted especially on the open when they set the market with their orders. When the equilibrium is skewed in one direction (ie. towards the buyers or sellers), the market maker will open the stock as far as possible in the direction of the skew. For example, if there is a huge demand on the open for a stock which exceeded the earnings estimates, the market maker will need to create the market by making these shares available from within their own inventory. Therefore, you can see how it would be advantageous to sell the stock at the highest possible price and buy it at the lowest possible price. Novice traders will put in market orders to buy or sell on the open and the market makers will legally take advantage of this. This is why you will see the stock put in a top or a bottom in the first couple minutes of the trading session.
One of the keys to being successful in day trading is being able to ride the coattails of the bigger institutional investors which are able to drive the markets in the direction that they want it to go. In this series of trading setups, you will understand how to trade with the smart money and stop chasing stocks.
Gap up and Gap Down
Let’s now go deeper in the structure of the gap. If you listen to some of the so-called “sophisticated traders”, they will begin to describe a host of gap types present in the market.
We have a full gap when the price opens below or above its previous high or low. In such case the last candle of the previous day and the first candle of the new day do not overlap, hence a full gap.
It is crucial to mention that full gaps have higher volatility and therefore could be considered riskier trades. Nevertheless, if traded properly, they could lead to attractive results.
We have a partial gap when the market opens with a gap but at some point overlaps with the last candle from the previous trading day.
Gap Trading Techniques
So, the morning comes and you see the big hole in the chart – the gap, now what?
When a stock has a full or a partial gap, the price immediately establishes two levels on the chart – a low and a high.
This is the 1-minute chart of Boeing, which shows the morning gap from July 24, 2015. I have indicated with 1) and 2) the last candle of the previous trading day and the opening candle. The blue lines show the highest and lowest points of these two candles.
Riskier Morning Gap Strategy
First, I will start with the riskier trading alternative on the morning gaps – placing trades after the first 30 minutes of trading.
After 30 minutes, if the price is above the high you settled, then you can attempt a long position. If the price is below the low, then you can try going short.
Let’s see how it works:
This is the 5-minute chart of Bank of America from July 22, 2015. The day starts with a full bearish morning gap equal to $0.05 (5 cents) of the BAC share price. As you see, I have identified the low and the high of the gap.
Then after 30 minutes, we see a candle close above the high of the gap. This is an indication that the market is willing to move upwards despite the bearish gap. We go long as a result of this counter trend rally and hold the stock for a healthy gain of 45 cents per share.
Less Risky Morning Gap Strategy
This approach works the same as the aforementioned strategy; the only difference is that after the gap we will give the price action at least one hour to develop. Again, we set our gap high and low taking the opening candle and the last candle of the previous day. After one hour, if the price is above the high or below the low, we take a position in that direction.
This is the 5-minute chart of Google for July 24, 2015. This time we have a bullish partial gap. The market opening brings the price above the previous candle, but the further price move goes below that candle. After one hour, the candle of the price is way below the gap low. This signals that despite the bullish gap, Google is in trouble. Thus, we short Google and as you can see, the stock price drops steadily generating a profit of $7.58 per share.
$7.58 is approximately 1.18% of the stock price – not bad at all! However, if we implemented the riskier strategy and had taken a position after the first 30 minutes, we would have generated profit of $10.25 per share. This is 1.61% of the Google share value, which definitely makes a big difference!
Nevertheless, remember, taking more risk doesn’t always equal more money.
Money Management and Morning Gap Trading
Like every other trading system, gap trading strategies should also include some basic money management rules. To this point, we will now cover how to set stop loss orders and when to take profits when trading morning gaps.
Stop Loss and Morning Gap Trading
When you want to enter the market after a gap, you need to define your stop loss levels. In other words, you should first decide how much you are ready to lose in case your morning gap system turns against you.
My advice for you is to place looser stops for the 30-minutes gap trading strategy and tighter stops for the 1-hour gap trading system. The reason for this is the increased volatility associated with trading shortly after the first 30-minutes requires a greater appetite for risks.
Conversely, after the first hour, you can use tighter stops as the market has had sufficient time to react to the morning gap. Hence, the stock is likely to have a significant move and quickly ending any hopes of a profitable trade.
This is the 5-minute chart of Oracle Corp. from October 1, 2015. I have added the volume indicator at the bottom of the chart in order to demonstrate the contrast of activity between the 30th and the 60th minute after the market open. The black arrows show you that the volumes at the 30th minute mark is twice as large as the 60th minute.
Still looking for a straight answer of where to place your stop, well look no further.
If you choose to trade using the 30-minute candle strategy, place the stop loss anywhere between 1.50% and 3.00% from the opening price. If this goes beyond the gap’s low or high level (depending on your position direction, then simply use the gap’s level to place your stop loss).
Please remember these are just notional values. You have to assess the volatility of each stock you trade. Meaning if a stock is up or down 40% on the day, 1.5% is like a blink of an eye.
If you choose the less risky strategy where we enter the market one hour after the gap, then you should place your stop loss order anywhere between 0.70% and 1.50% from the opening price.
Based on our previous chart examples this would result in the following stop loss orders:
You want to go long on Google 30 minutes after the morning gap. You buy the GOOG stock at $638.00 per share. This means that your stop loss should be placed at a level anywhere between $628 and $619.
You want to short Oracle one hour after the morning gap. You short the ORCL equity at $38.20 per share. Since you are choosing the less risky strategy, you can put a tighter stop. In this case, your stop loss should be located between the levels of $38.46 and $38.77.
Taking Profits on Morning Gaps
There are a host of profit taking strategies you can use to manage gap trades. Some of these include moving averages and per trade profit targets. In this article, we will explore the option of using trailing stops for exiting winning trades.
Simply put, place a .33% trailing stop order once the profit targets discuss in the previous section are reached. As long as the stock does not give back .33% at any given point, sit back and enjoy the ride.
- Morning gaps occur as a result of overnight or early morning news events.
- Morning gaps are:
- Morning Gaps could also be:
- Full Gaps
- Partial Gaps
- Gaps have a low point and a high point relative to the previous day’s close.
- Some of the profitable ways to trade morning gaps are:
- The riskier gap trading strategy: To enter the market based on the price action after the first 30 minutes.
- The less risky gap trading system: To enter the market based on the price action after the first hour of trading.
- Always place a stop loss orders when you trade gaps:
- If you trade after the first 30 minutes – place the stop on 1.50%-3.00% from the entry price.
- If you trade after the first 60 minutes – place the stop on 0.70%-1.50% from the entry price.
You can take profits by simply setting a trailing stop, which will chase the price if the stock trends in your direction.