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Gap Trading Techniques

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Finding a strategy that

back-tests successfully is rare;

find-ing one that is reproducible in

live trading is rarer still

The following intraday strategy — the

Morning Gap Reversal (MGR) —

capital-izes on the major indices’ tendency to

retrace toward the prior day’s close each

morning It has a high winning perc e n t a g e

tested in both bull and bear conditions —

an important characteristic for any

short-term strategy — and it is easy to execute

Each morning the opening price of an

index or stock is higher or lower than the

prior day’s closing price This price

change is called the morning gap if it is

above the previous day’s high (an “upgap”) or below the previous day’s low (a

“down gap”) However, for simplicity,

we will use “gap” to refer to the distancebetween the previous close and currentopen, regardless of whether or not theopen falls within the previous day’srange (see Figure 1)

First, we will analyze the behavior ofmorning gaps to determine if they pro-vide a logical basis for a trading strategy

Morning gap statisticsStatistically, price has a very high likeli-hood of filling between 50 and 100 per-cent of the gap between yesterd a y ’ sclose and today’s open during the trad-ing day Usually, a reversal that fills (orpartially fills) the gap will occur withinthe first 30 minutes of trading (by 10 a.m.ET)

T h ree years of back-testing fro mJanuary 1999 to January 2003 on theDow Jones Industrial Average (INDU),S&P 500 (SPX) and Nasdaq 100 (NDX)indices was conducted to verify the sta-tistical reliability of the basis for theMGR strategy The analysis wasdivided into three parts: first, deter-mining the frequency and extent ofmorning gap reversals; second, find-ing out how quickly morning gapsreversed; and third, identifyingimportant “time markers” withinthe reversal period

Table 1 summarizes the first part

of the analysis The columns showdifferent gap sizes, from 1 to 3 per-cent (positive or negative) The rowsshow what percentage of the gapswere filled, and the cells show howoften they were filled (at some pointduring the trading session)

The table shows 85 percent of thegaps between zero and 1 percent insize (positive or negative) closed atleast halfway, and 78 percent of thegaps closed between 90 and 100 per-cent

Although slightly less re l i a b l e ,gaps between 1 and 2 percent (posi-tive or negative) showed a similartendency to be partially retraced or

S&P 500 index-tracking stock (SPY),

one-minute

In the first half-hour of the trading session, the market will frequently retrace in

the direction of the previous day’s close.

FIGURE 1 MORNING “GAPS”: REVERTING TO THE CLOSE

Source: Great-Trade by Protrader

BY BRYAN C BABCOCK AND ARTHUR AGNELLI

Historical tests reveal the tendency of the major stock indices to revert to the previous day’s closing price in the early minutes of the trading session This

strategy takes its cue from that bit of market behavior.

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filled These gaps retraced by at least

half 78 percent of the time and retraced

between 90 and 100 percent 62 percent of

the mornings studied Gaps in the 2- to

3 - p e rcent range were somewhat less

likely to be filled

Only 14 percent of the gaps (in the

“Overall” column) closed between zero

and 9 percent, which includes those

mornings when price immediately

moved in the opposite direction of the

gap closure, creating what is known as a

“gap and run.”

The second part of the analysis

e x p l o red how quickly gaps re v e r s e d

The gaps typically closed half way (50

percent) by 9:55 a.m Of the gaps that

closed completely, 67 percent of them

did so in the first 30 minutes of the

trad-ing session, and 86 percent closed by the

end of the first hour of trading (10:30

a.m ET) The likelihood of additional

closure declined substantially after the

first hour of trading Gaps that were still

open after 60 minutes closed only 4.5

percent of the time Also, the success rate

diminished on days when economic

news was released 30 minutes after the

market open, at 10 a.m ET

The third portion of the analysis

iden-tified important time markers during the

g a p - reversal period Figure 2 (below)

shows the typical time markers for gap

reversals Just after the open, the major

indices tended to continue to move in the

d i rection of theopening price forthe first one to 10minutes A f t e rthis initial rally(or sell-off), themarket turnedand began toclose the morn-ing gap Thisreversal, on aver-age, began sixminutes after theopen, at 9:36 a.m

four-minute countertrend move (or “jig,”

which often fakes out traders into ing positions early) typically occurre d

cover-a round 9:42 cover-a.m cover-and lcover-asted until cover-appro imately 9:47 a.m

x-Before the bell:

Pre-market review processThe first step in trading the MGR is antic-ipating the direction of the openingmove Usually two hours before the mar-ket opens a reliable gap can be identified

by checking the pre-market stock index

f u t u res quotes on CNBC or Bloomberg

T V (Minute by minute pre-market index

f u t u res quotes are also available thro u g hthe Chicago Mercantile Exchange We bsite, w w w.cme.com.) Whether these con-tracts are trading up or down in the earlymorning can give you an indication ofthe possible direction of the stock market

o p e n Second, make note of how the futuresare affected in the pre-market by anyeconomic reports released at 8:30 a.m

E T This will indicate whether thefutures are strengthening or weakening

in pre-market trading Make a finalcheck of the futures at 9:10 a.m (20 min-utes prior to the market open)

Morning open — up gap

Morning peak on average 9:36 a.m EST

The primary time “milestones” in early trading show the

retracement to the previous close typically maximizes

around 9:53 a.m.

FIGURE 2A MORNING UP-GAP TIME MARKERS

The time markers for the typical down gap are the same

as those for up gaps

FIGURE 2B MORNING DOWN-GAP TIME MARKERS

Prior day closing price Prior day

closing price

Morning open — down gap

Trade is maximized 9:53 a.m.

Trade is maximized

The columns show morning gaps of different sizes

The rows indicate how much of the gaps were filled.

TABLE 1 MORNING GAP ANALYSIS

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T h e re are two qualifications for the

behavior of the futures in pre - m a r k e t

trading First, all three index futures

con-tracts (S&P, Nasdaq 100 and Dow) must

trade consistently in the same dire c t i o n

during the pre-market For example, if

the Dow futures are down 35 points at 8

a.m and rally to trade up 20 points by 9

a.m., they have changed from implying a

down opening to implying an up

open-ing This kind of behavior should not be

traded Similarly, if one contract is up

and the other is down (e.g., the Nasdaq is

up 5 and the Dow Jones is down 15), it is

not a good day to use the MGR strategy

Second, because a very narrow gap

reduces profit potential, gaps in the

futures contracts must be in excess of 5

points for the S&P 500 futures, 10 points

for the Nasdaq 100 futures and 20 points

for the Dow Jones futures

Other factors

In addition to watching pre-market

trad-ing activity, evaluate the support and

resistance in the market you intend to

trade Be aware of the projected opening

price of the security relative to any

sig-nificant support or resistance levels

Often a market that is gapping up will

open just under an established resistance

level; a market gapping lower might

open just above established support

Both indices and stocks exhibit themorning gap characteristics outlined

h e re Index-tracking stocks such asQQQ, DIA, or SPY are good vehicles fortrading the MGR strategy because, notbeing subject to the up tick rule, they areeasier to sell short than individual equi-ties For these reasons, it is recommend-

ed that you concentrate on the threemajor index-tracking stocks when trad-ing the MGR strategy

Trade entry The average reversal start time is 9:36a.m., which means the trade-entry win-dow is generally from 9:30 to 9:42 a.m If

a position has not been initiated by 9:42a.m., no trade is taken for the day Threeentry techniques can be used with theMGR strategy: time entry, pattern entryand staggered entry

A time entry consists of “playing theaverages” by entering a trade at 9:36 a.m.,

re g a rdless of what the market is doing atthe time This approach has the advantage

of being easy to execute, but it also ru n sthe risk of putting you immediately on thelosing side of the market Despite thesedisadvantages, a trader without a re a l -time trading setup system may prefer thismethod because of its simplicity

The pattern entry approach waitsfor the market to reverse toward the

p revious closing price before ing the trade The trade is taken onlyafter two complete one-minute bars

enter-in the direction of the reversal (i.e.,bars with closes below their opens,and the second bar with a lower lowthan the previous bar, if the re v e r s a l

d i rection is down), as shown in

F i g u re 3) The advantage of this

a p p roach is that by waiting for themarket to confirm the reversal prior

to entry, the trader avoids entering alosing position on days when themarket keeps running in the dire c-tion of the opening gap The disad-vantage is that the trader is alwayslate getting into the market and maymiss significant profits as a result The staggered entry combines thefirst two approaches by bre a k i n gthe entry into two equal halves Thefirst half of the trade is placed at 9:31a.m and the second half of the trade

is entered after two bearish minute bars in the direction of thereversal This way, if the marketreverses quickly, the trader has apartial position already in the market

one-H o w e v e r, if the market runs in the dire tion of the open, only half the trade isexposed

c-Stop placementEvery trader’s primary focus should be

c o n t rolling risk and losses Most traders

a re quick to take a small profit when themarket is willing to give a larger pro f i t ,while at the same time they expose them-selves to too much initial risk and areslow to take losses The following guide-lines are designed to let the market con-

t rol your profit while you control yourrisk

The strategy uses three kinds of loss orders, the sizes of which areintended for SPY, DIA and QQQ Thefirst type is the “high-low” stop Theprimary risk in an MGR trade is themarket will continue to run in the dire c-tion of the gap There f o re, if the index-tracking stock trades 15 cents above thehighest high of the morning (for upgaps) or below the lowest low of themorning (for down gaps) after 9:45 a.m.,the position should be closed This is theworst-case scenario and will yield thestrategy’s largest losses

stop-The second stop-loss is a trailing stop

One way to enter a trade is to wait for two consecutive bars that close lower than

they open (in the case of a downward reversal and potential short trade), with the

second bar also having a lower low than the first bar

FIGURE 3 PATTERN ENTRY

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that requires evaluating where the

trade is relative to the best price it

has experienced up to that point

First, once a 25-cent profit has been

reached, move the stop to

breakeven When a 35-cent profit

is in place, trail the stop-loss 25

cents above the highest high (for a

short trade) or below the lowest

low (for a long trade) reached

dur-ing the trade

For example, if the position is

up 35 cents and moves back to

being up only 10 cents, exit the

trade; if the position is up 50 cents

and moves back to being up only

25 cents, exit the trade This

a p p roach continually moves the

stop in the direction of the trade

The third stop is the “time

stop.” Because this strategy is

most successful in the first 30

min-utes of trading (and because

eco-nomic announcements often occur

at 10 a.m ET), the time stop

liqui-dates any position that is still open

at 9:55 a.m This allows the trader

to take advantage of the most

ben-eficial time period without exposing the

trade to the volatility of adverse

reac-tions to news

In actual trading, the majority of

los-ing trades are stopped out with a loss of

50 cents or less In tests, a 50-cent

absolute stop in the SPY and DIA w a s

r a rely hit The lower price of the QQQ

made them even less susceptible to being

hit; the typical maximum loss in the

QQQ is closer to 30 cents than 50 cents

Position sizing

Correct position sizing will enable you

to focus on the strategy without being

distracted by unnecessary anxiety A

benchmark is to risk no more than 2

per-cent of account equity on a trade This

means a trading account of $25,000

could aff o rd to risk $500 per trade

($25,000 x 02 = $500) Because this

strat-egy typically stops out a losing trade

within 50 cents of the entry, it’s possible

to trade up to 1,000 ($0.50 x 1,000 = $500)

shares

C a v e a t s

The stop-loss rules are structured to let

the market determine how large the

profit should become when the trade

runs in the desired direction

However, when the gap closes

entire-ly before 9:55 a.m., half the positionshould be closed (The prior day’s close

is a natural resistance/support level; if it

is penetrated, the possibility of a around off that level emerges.) The sec-ond half of the position should be keptopen in case the market continues tomove profitably

turn-Finally, the “jig” mentioned in the tistics section occurs quite fre q u e n t l ybetween 9:42 and 9:47 a.m ET Becausethis countertrend move can fool a traderinto closing a position too quickly, try toavoid closing a position during this timeframe Stick to your original stop-losslevels

sta-Trade exampleFigure 4 shows the Dow Jones IndustrialAverage tracking stock (DIA) openinghigher (on Jan 23, 2003) than the preced-ing close, setting up a potential shortsale

Using the simplest entry approach, ashort trade was entered at 9:37 a.m ET at

$83.74 (the market was already starting

to retrace toward the previous closingprice of $83.24) The initial stop-loss wasplaced at $84.07, which corresponds tothe morning high plus 15 cents (Thechart also shows where the pattern entry

technique could have been used.) The market continued to move lower,first reaching the 25-cent profit level atapproximately 9:41 a.m., at which pointthe stop is moved to breakeven Next,DIA reaches the prior day’s closing pricearound 9:48 a.m When this target wasreached, 50 percent of the position wasclosed for a 50-cent profit

F rom this point onward, the balance ofthe position would be exited with the 25-cent trailing stop or at 9:55 a.m., whichev-

er comes first In this case, the time stopwas reached, closing the second half ofthe trade at $83.47 for a 27-cent profit Thetrade’s total profit was just over 38 cents,taking into account the two exits Statistical foundation

and tight risk controlThe MGR strategy is based on the favor-able statistical performance of earlymorning reversals back to the previousday’s closing price It combines a highwinning percentage with conservativerisk management

The strategy’s simplicity makes iteasy to monitor and “paper-trade” inreal-time, which lays the groundworkfor actual trading.Ý

For information on the authors see p 12.

In this case, the entire morning gap was filled in the first 20 minutes of trading,

at which point half the trade was liquidated and a 25-cent trailing stop was used to protect the remainder.

FIGURE 4 SHORT-TRADE EXAMPLE

Dow Jones Industrial Average index-tracking

stock (DIA), one-minute

Exit 50 percent of the position (at 83.24) when the entire morning gap is closed

Exit remainder of position at 9:55 a.m ET(83.47)

Pattern entry(Two consecutive one-minutebars in the direction

of the reversal)Entry:

Price — 83.74Time — 9:37 a.m ET

Initial stop-loss is placed at themorning high plus 15 cents

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I n today’s markets, many stocks

can have large supply-demand

imbalances at the opening bell

Often, these imbalances result in

what are known as gaps, when the

open-ing price is higher or lower than the

pre-ceding close

News, in various forms, is generally

the catalyst for gap openings The most

common type is macroeconomic news

such as FOMC meetings, the release of

economic indicators such as

unemploy-ment or the Consumer Price Index (CPI),

or stock-specific news such as earnings

surprises or analyst upgrades or

down-grades

When buying interest exceeds sellinginterest, the gap will obviously be to theupside and vice versa However, what isnot known is the price level at which thestock will open, and the precise risksassociated with being long or short in aparticular situation

Until recently, these price levels wereoften determined exclusively by large

“off-floor” markets, such as Instinet, aninstitutional trading network that wasthe first outside-market-hours tradingmedium To d a y, with the advent ofmany other Electronic CommunicationsNetworks (ECNs), there are many moreretail traders active in pre- and post-market trading However, even thoughthe public has access to the pre-market,the levels that trade pre-market are stillmostly influenced by market makerswho bid or offer stock at price levelsaway from the previous day’s closewhen imbalances appear in their auto-mated systems

Because many of these imbalanced

o rders are “market on open ord e r s ”(meaning they are to be executed at the

“best” available price as soon as the

mar-ket opens), marmar-ket makers have anincentive to open a stock at extreme lev-els directly correlated to the imbalance.This simply means that if an imbalance

is on the demand side, and a given stock

is going to open strong, market makerswill open it as high as they can, takingthe opposite side of the trade on openbuy orders

Because most members of the publictrade only the long side of the market,many unsuspecting amateurs buy intogap-up openings at what often will bethe high price of the day As a result, it isworthwhile to explore the possibility oftrading situations when a gap will nothold (reverses), rather than thoseinstances when the stock followsthrough with a move in the same direc-tion Whether the stock reverses andcloses the gap or follows through in thesame direction, this move is perhaps thestrongest indication of what the trendwill be for the stock shortly after the gapopening In the example of bullish gaps,stocks that fail to meet new highs fromthe opening levels will have a greaterlikelihood to retrace and lose much of

comes the higher risk of opening gaps.

Learn how to spot the early warning signs

and how to take advantage of them.

The first clue that a stock is ripe for a gap opening

is an increase in volume over its normal daily average.

BY DAVID S NASSAR

TRADING Strategies

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the opening gap.

C o n v e r s e l y, stocks that re m a i n

strong and trade to new highs after the

opening gap will have a greater

likeli-hood of following through and

trend-ing higher While this shouldn’t be

interpreted too rigidly (there are other

indicators to monitor, such as index

strength and sector strength, etc.), it is

the strongest single indication of how a

stock will trade following a gap

open-ing

Regardless of whether gaps are to

the upside or downside, it is important

to study the impact they have on

stocks The following components and

considerations are most important

when trading gaps:

• Charged stocks/sectors;

• Volume and volatility;

• Chaos and over-activity;

• High risk (elasticity)

Let’s look at each of these factors

Where the action is:

Charged stocks and sectors

Once a sector is in the public eye, think

of the component stocks as being

pumped up or “charged.” When this

occurs, the volume in the stock will

increase, and there will be a

tremen-dous swing in the trading range from

one session to the next, either to the

upside or downside Before the

open-ing bell, in the absence of actual trade

a c t i v i t y, market makers will pre d i c t

price pattern changes — either slightly

before an event or immediately after one

— and bid the stock higher or lower

based on their predictions

If a major stock within a sector

experi-ences negative or positive news, it can

charge an entire sector Figure 1 shows

Intel (INTC) gapping down after

nega-tive news on inventories The entire

Philadelphia semi-conductor index

(SOX) became charged and volatile

immediately after As you can see fromthe chart, Intel did not hold its levelsafter the first gap and followed through

by trending lower, as did the SOX index

Early warning signs:

Volume and volatility The first clue that a stock is ripe for a gapopening is an increase in volume over itsnormal daily average Often, the volume

increase will occur before the news isknown This is an indication that news isleaking in the market and explains thecliché “stocks tell their own story” ahead

of news Remember, the biggest tradinghouses often have strong indications ofsector and stock stre n g t h / w e a k n e s s

b e f o re the media There f o re, whenincreases in daily volume accompanied

by directional bias are seen in theSource: QCharts by Quote.com

Starting in September 2000, the uptrend in Intel (top chart) came to a halt, punctuated by a series of downside gaps Typically viewed as a blue-chip stock free of extreme volatility, Intel became much more volatile after the first down gap; it became a "charged" stock that propelled the entire semiconductor sector lower (bottom chart).

FIGURE 1 CHARGING LOWER

Intel (INTC), daily

PHLX Semiconductor Sector Index (SOX), daily

75 70 65 60 55 50 45 40 35

1200.00 1150.00 1100.00 1050.00 1000.00 950.00 900.00 850.00 800.00 750.00 700.00 651.22 600.00

300,000,000 200,000,000 100,000,000 0 Volume

28 5 11 18 25 2 9 16 23 30 6 13 Sept Oct Nov.

2 1 28 5 11 18 25 2 9 16 23 30 6 13 Sept Oct Nov.

391⁄32

74,009,300

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absence of news, a gap is generally not

far behind

The best way to track volume is by

knowing the average daily volume for

the stock or sector in question, in

combi-nation with its key trading levels

(sup-port or resistance) Watching the time

and sales ticker is an excellent way to

monitor changing volume for short-term

intraday trades If the ticker is moving

fast, you are seeing an increase in

vol-ume — it’s that simple

When this occurs, you are generally

looking at a “vertical spread” (VS)

situa-tion A high VS means the price pattern

is changing rapidly, up or down, and

you will need to “lead” the market (i.e.,

place a limit order that is the best bid or

offer) to buy or sell as the range widens

A slower-moving issue that has a tight

“horizontal spread” (HS), where the

spread between the bid and ask is tight,

say 1⁄16, will not require leading If the

stock has a tight HS, you can easily “lift

offers” or “hit bids” — or even buy bids

and sell offers –— during tight price

range situations

To spot volume changes that may lead

to gaps, it is important to take a broader

view of both the volume and the market

itself Notice the dramatic volume

increase in Intel over the course of

sever-al days, in Figure 1 However, the

vol-ume interpretation changes within each

move and the stock will move the most

on the least volume once it is in motion

For example, when stocks are growing

weaker, panic and fear is heightened and

fewer buyers are stepping up Therefore,

as buyers disappear from the market,

stocks fall harder on light volume and

with a wider range before new support

levels are found Once the stock

estab-lishes support levels, the volume builds

dramatically as buyers remain strong,

while sellers are still in the market It is

at these levels that the true battle

between bulls and bears takes place

These campaigns are evidenced by

heavy buying and selling, which result

in small price movements until one sideultimately gains control Once a clearimbalance is revealed, whether bullish

or bearish, the volume tends to dry up asmarket participants start to lean over toone side of the supply/demand scale

For example, if the bulls gain control at a

key support level, buyers will exceedsellers and the stock will trade higher onless volume as the buyers lift thin offers

at each price level

The lesson here is that volume cates where the battles are foughtbetween bulls and bears, but once adominant bias is revealed, the stock willmove the most on lighter volume Gapsare the ultimate example of this: no vol-ume exists, but extreme price changedoes Once this gapping action begins,chaos is not far behind

indi-Chaos and high risk:

Are gaps worth it for you?

Chaos reaches its peak when stocks have

no real support or resistance levels insight For example, if a stock is not wellsupported until it trades 20 points lower,volatility will be extreme

These such conditions re p resent aday-trading environment only This isnot a time to take overnight positions

Remember, volatility can also be defined

as chaos and, therefore, you can throwyour technical tools and indicators outthe window If you want to day trade inthis climate, you must take a micro view

of the stock, taking small incrementalprofits and losses vs trying to trade theoverall trend

Also important is that gaps oftenreveal the beginning of new tre n d s However, if you’re a longer-term posi-tion trader in these situations, you musthave a much higher risk tolerancebecause these price fluctuations are part

of the equation Otherwise, you will stantly employ “discipline” at the wrongtime (placing stops too close, etc.) and

con-get whipsawed out of trades, takingmany losses Certainly, you also need aclear picture of what the broader priceaction looks like before even thinkingabout adding volatile, big-range stocks

to your watchlist It is also important todramatically lower your size in thesetrades, because the range of the price

swings offsets the trade size needed toprofit

Seeing the broader view of the market

is like a hurricane: When you’re in it, it ischaos, but if you can get far enoughaway, you can see the larger pattern and

d i rection When you trade chaoticstocks, you must trade them accordingly

or avoid them altogether

To determine if a chaotic market mate in general, and the overnight-gaptrade in particular, is for you, ask your-self the following questions:

cli-1 Do I have the account size required

to take the necessary risk?

2 Do I have the temperament and

the required level of risk tolerance?

3 Am I “in the money” and willing

to take on additional risk for additional reward?

4 Do I have clarity and confidence

enough to see the gap coming?

5 Did I day trade this stock the entire

day prior to the anticipated gap?

If you answered “no” to any of thesequestions, don’t even think about takingthe trade If you answered “yes” to all ofthe questions, then you have the criteria

to attempt it Here’s how to do it.Taking the trade

Let’s begin with the fact that, because ofvolatile price pattern movements duringthe day, stocks will tend to overreact orovertrade, moving to extreme price lev-els that are extreme This sets up a possi-ble correction for the next trading ses-sion, when market makers will often gapthe stock price to levels that are advanta-geous for them

The first gap that sets the stock in

Stocks tend to overreact and move to extreme price levels,

which sets up the possibility

of a correction in the next trading session.

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motion because of unforeseeable news is

generally not predictable However, the

gaps that may follow can occur for some

of the following reasons:

• Additional news, such as earnings

releases

• Short squeezes and profit taking

(“hook” closes)

• S&P 500 futures volatility

These different factors can provide

various signals that offer opportunities

for gap trades

Earnings Earnings are perhaps the

most significant factor re g a rding gap

trades, because they have such a

sub-stantial impact on both stocks and

sec-tors

The market is far more unforgiving of

missed earnings than it is re w a rding to

earnings that meet estimates Many

com-panies meet expectations and still get

h a m m e red the day after their

announce-ments This is because most positive ings expectations are built into the stockprice in the days prior to the report Forthis reason, stocks have a greater pro p e n-sity to fall when companies merely meet

earn-e x p earn-e c t a t i o n s When expectations are missed, thedownside bias is dramatic Therefore,you should rarely take an overnightposition in a company that is reportingearnings after the close If you do, yournatural bias should be to trade the shortside — especially in this market environ-ment, where good earnings are often nomatch for inflationary pressure, risinginterest rates and oil prices

Because so many stocks have anupside bias in the days prior to an earn-ings report, it is best to sell into the news

if you’re long the stock, and wait for theoutcome Figure 2 is an example of whatcompanies experience when they miss

expectations

Short squeezes and profit taking.

Short squeezes and profit taking are themost common reasons stocks will tend tobuild above-average volume into theclose and cause what is called a “hook”close

In a short squeeze, a stock is in a

d o w n t rend and market makers suspect

t h e re may be many short sellers in themarket The squeeze and the hook occurwhen the professionals begin to buy thestock rapidly into the close, causing price

to rise swiftly and forcing the short ers to cover in a panic Profit taking gen-erally occurs when a stock is in a rising

sell-t rend busell-t shows a weak close nied by high volume At this point,traders with long positions begin to sellthe stock to take a profit Figure 3 shows

accompa-an example of a short squeeze, while

F i g u re 4 is an example of a hook formedSource: QCharts by Quote.com

Leading up to the earnings release on Oct 27, shares of American Power Conversion (APCC) traded from 18 to 22 in five days The earnings didn’t live up to expectations and the stock gapped nearly seven points lower the following day.

FIGURE 2 EARNINGS DISAPPOINTMENT

American Power Conversion (APCC), 10-minute

22 21 20 19 18 17 16 15 14

13 1 ⁄ 16

1,000,000 500,000

255,300

0 Volume

11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 1 1

10/20 Friday 10/23 Monday 10/24 Tuesday 10/25 Wednesday 10/26 Thursday 10/27 Friday 10/30 Monday

Trang 10

during profit taking

If you’re not in a profitable situation

from day trading the stock, you should

not take the overnight gap trade It is

best to stand aside and trade the open

the following day, after the stock gaps

open — if it does If you had a profitable

day-trading session, you can take the

overnight position if you think the

risk-re w a rd risk-relationship is satisfactory

R e m e m b e r, when going after an

overnight position, it must always be

with purpose and confidence Never

hold a losing position overnight, hopingthe stock will “come back.” That is noth-ing but gambling

S&P 500 futures S&P 500 futures are

an important consideration when taking

an overnight gap trade You should look

at the correlation between the futuresmarket and the index in relation to thegap-trading plan you have in mind Ifthe futures are moving decisively highergoing into the close, and you have otherindependent reasons for the stock inquestion to gap higher the next day, and

all other questions and factors can be

a n s w e red favorably, you could keepyour long position overnight

The point is you must have clarity andconfirmation on all levels when taking aposition overnight Still, the most signif-icant piece of information comes fromthe stock itself and how it behaved whileyou where trading and watching it in thedays prior to the anticipated gap.Without this information, you will not

be able to make a decision whether totake a gap trade or not

Gap trading is a risky business, andthe professionals who quote stocks up ordown prior to the open have a vested

i n t e rest in doing so If you were a marketmaker who made your living buying andselling stocks from the public while pro-viding liquidity to the market, wherewould you open a stock with poor newsknowing you were to receive market on

The first gap that sets the stock

in motion because of unforeseeable news

is generally not predictable.

Source: QCharts by Quote.com

On Oct 26, Amgen (AMGN) closed the day near its high on a sudden spurt of buying that was likely the result of a short

becoming resistance.

FIGURE 3 SHORT SQUEEZE

Trang 11

open orders? You would open it as low as

possible, where you felt the stock was

well supported This is known (from the

market maker’s perspective) as “buying

w e a k n e s s ”

Conversely, with strong news,

know-ing you would be sellknow-ing at the open,

where would you open the stock? The

higher the better, so that you could short

stock to buyers at what would be a nificant resistance level This is referred

sig-to as “selling strength.”

This is why gaps have a greater pensity to close immediately after theopen: After the initial panic selling ormania buying has been gobbled up by themarket maker or specialist, a vacuumoften develops and the stock will re v e r s e

pro-By contrast, if the stock continues to

fol-l o w - t h rough in the direction of the gap, it’s

a strong indication that the trend will tinue

con-Remember, however, that while theserules are good to use as a guide, theyshould not be traded with indiscretion.There are many factors that impact anyindividual gap-trading situation.ÝSource: QCharts by Quote.com

Transwitch Corp (TXCC) was on its way to recovery from a sell-off in the fiber optic group Along the way, profit taking

on Oct 30 forced the price lower at the end of the day The next morning the stock gapped higher, with the buyers once again firmly in control.

FIGURE 4 PROFIT-TAKING

Transwitch Corp (TXCC), 5-minute

56 54 52 50 48 46 44 42

200,000 150,000 100,000 50,000

The market is far more unforgiving of missed earnings

than it is rewarding to earnings that meet estimates

You should rarely take an overnight position in a company that is reporting earnings after the close If you do,

your natural bias should be to trade the short side.

Trang 12

Trading Strategies

&

FUTURES OPTIONS

Watching pre-market volume is a good way to determine whether

to trade or fade the opening move.

BY JOHN CARTER

distance between the

reg-ular-session opening price

and the previous day’s

closing price — are stomach-churning

events when the market makes a big

move against you, but they represent

low-risk trade opportunities if you know

which gaps are likely to be followed by

predictable patterns

In terms of the price behavior that

fol-lows opening gaps, not all markets are

created equal Gaps in individual stocks

and commodities do not act the same as

those in “multi-item” instruments such

as stock indices because a news item willcontrol the entire market instead of just aportion of it Earnings announcements,corporate scandals and other company-specific events can create gaps in a com-ponent stock’s chart that never get filled

Because of the unpredictable nature ofvarious events that can impact the price

of an individual stock, they make poorcandidates for the opening-gap trade

In contrast, stock index futures such asthe E-mini S&P (ES) or the mini-sizedDow (YM) are better candidates foropening-gap plays because they consist

of multiple components that respond

dif-f e rently to news For example, although astock index futures contract may gap up

on a news item, there will be individualstocks within the index that will either

i g n o re the news or sell off This weighsthe index down and creates a tradeopportunity as the market fills the gap

The best markets for gap plays The S&P 500 and the Dow are the bestmarkets to trade the opening gap

because of the diversity of their nent stocks Both indices re p resent collec-tions of stocks from diff e rent industriesthat are more likely to react independent-

compo-ly to news events In the heavy Nasdaq, opening price gaps cantake longer to fill because the majority ofthe stocks will react similarly to news The key to trading opening gaps isbeing able to predict the likelihood aparticular gap will be filled Dissectingthe market conditions that produce agap is as important as analyzing a gapitself For example, an opening gap fol-lowing high pre-market cash tradingvolume can take weeks to get filledbecause high volume increases the oddsthe market will continue to move in thedirection of the gap

technology-Some of the biggest gaps are caused

by major news events, such as the break of a war, but gaps caused by minornews items are much more common

out-G e n e r a l l y, such gaps are smaller, fillquickly (see Table 1) and can be “faded”(the act of trading against the direction

of the gap) more effectively Let’s look at

Between Jan 15, 2002, through

February 2004 (528 occurrences),

an average of 76 percent of all

opening gaps closed at some point

during the same day This is the

breakdown by day of week Adding

the pre-market volume filter

increased the percentages.

TABLE 1 FILLING THE OPENING

GAP: RAW DATA

The higher the volume, the greater the likelihood the market will continue

in the direction of the opening gap As a result, no trade is taken when vol ume is above 70,000.

-TABLE 2 TRADE MANAGEMENT GUIDELINES

Pre-market volume

Trang 13

the specific criteria for identifying those

gaps with the best chances of reversing

The pre-market volume indicator

The most important indicator for

deter-mining which opening gaps can be

faded is the pre-market volume in a

spe-cific set of stocks

Check the pre-market volume at 9:20

a.m ET (10 minutes before the re g u l a r

cash session opens) in the following

stocks: KLA-Tencor Corporation (KLAC),

Maxim Integrated Products, Inc (MXIM),

Novellus Systems, Inc (NVLS) and

Applied Materials, Inc (AMAT) These

re p resentative stocks were selected

t h rough a trial-and-error pro c e s s

If the market is really set up to move,

there will be significant volume in the

cash market in pre-market trading If the

market is setting up for a “head fake” (a

move in one direction that is quickly

reversed), pre-market volume will be

low, which reflects a lack of conviction in

the move This is the preferred setting

for an opening-gap trade

If the pre-market stocks have each

traded less than 30,000 shares at this

time, analysis of the prior 500 trading

days shows the opening gap, up or

down, had an 80-percent chance of

fill-ing the same day However, if the

vol-ume for each stock is between 30,000

and 70,000, the gap only has about a

60-percent chance of filling that day, while

the midpoint of the gap has an

85-per-cent chance of being hit

Finally, if the pre-market volume for

each stock is above 70,000, the chances of

the gap filling that day drop to 30

per-cent In these cases, you should ignore

the news and follow the direction of the

gap Table 2 provides guidelines for

using volume information to manage

trades As the volume increases, the

position size shrinks and the

profit-tak-ing becomes more conservative

If one stock has volume above 70,000

but the others are below the threshold,

check to see if the news pertains to this

company alone If it does, ignore it If the

news is not specific to the company,

trade the more conservative position

The strategy

Figure 1 is a five-minute chart of the

mini Dow futures You can use any timeinterval — a one-minute, five-minute or15-minute chart, etc — as long as youcan view the opening This means thechart must be set up to reflect the open-ing and closing of the regular tradingsession, 9:30 a.m to 4 p.m ET (4:15 p.m

for stock index futures prices) Manytraders are used to watching a separatechart of the continuous 24-hour futuressession, but of course, opening gaps

won’t show up

Figure 1 shows the first day in a set ofback-to-back earnings announcementsthat caused opposite reactions in themarket On the morning of Oct 15, 2003,

the Dow gapped up 47 points as a result

of a positive earnings report from Intel(INTC) On this day, pre-market volumewas below 30,000

As a result, the appropriate trade is toimmediately short the gap on the openusing a full position size, as indicated inTable 2 To keep things simple, we’ll usenine contracts as a full position, whichmakes a two-thirds position six contractsand a one-third position three contracts

We will use a $100,000 account, whichmeans we are trading one contract foreach $11,100 in the account for a full posi-tion Although you can trade a mini Dow

or E-mini S&P contract with only a few

Mini Dow futures (YM), five minute

Gap is filled for a 47-point gain, or $235 per contract (47 points x $5 per point).

11:00 12:00 13:00 14:00 15:00 9:00 10:00

10/15/03

9,8309,8209,8109,8009,7909,7809,7709,7609,7509,7409,7309,7209,7109,700

This 47-point-plus opening gap in the mini Dow futures was filled in the first hour of trading for a $235 per-contract profit.

FIGURE 1 THE OPENING GAP

Source: eSignal

If the market is poised to move, there will be significant pre-market volume

in certain stocks.

Trang 14

FUTURES OPTIONS & Trading Strategies continued

thousand dollars, this trading plan

con-t rols risk by limicon-ting exposure re l a con-t i v e

to the amount of available capital Use a 1:1.5 re w a rd/risk ratio (risking1.5 points to make 1 point) for gaptrades that are less than 40 mini Dow

points or 4 E-mini S&P p o i n t s For gaps

l a rger than these, use a 1:1 re w a rd / r i s kratio In the case of Figure 1, we wouldrisk 47 points to make 47 points If thegap had been 30 points, we would risk

45 points

Some traders might question an

a p p roach that risks more than thepotential profit Most beginning tradersare taught to use a 3:1 reward/riskratio, risking 1 point to gain 3 Theyinevitably wonder why they are repeat-edly stopped out just before the marketturns In general, wider stops producemore winning trades; the key is to tradeonly those setups with a better than 80-percent chance of winning

The market sold off immediatelyafter the bell, filling the opening gapwithin an hour Ironically, the next dayIBM came out with a disappointingearnings report, knocking the market

down on the open Figure 2 shows the

resulting buy setup had just a smallopen loss at one point, although manytraders might have been stopped out

on the pullback around 11 a.m ET.However, keep in mind the strategy

is to maintain a reward/risk ratio of1:1, not to tighten your stop whenthe market moves in your favor Ifthe stop had been hit, the loss wouldhave been approximately $305 percontract ($2,745 for the nine-contractfull position), not including slippageand commissions This loss is rea-sonable because of the 80-percentsuccess rate of the setup

Using a tighter initial stop or ing stop would have turned thisposition into a losing trade or, atbest, a breakeven trade Using therisk parameters designed for thistrade setup allowed the position toremain open until the gap was filledfor a gain of 61 points As a rule,using a trailing stop will negativelyaffect the gap trade’s win/loss ratio When the trade is executed, thebest thing a trader can do is to walkaway and let the orders do theirwork This is the diff e rence between

trail-p rofessionals and amateurs:

P rofessionals won’t second-guess a

E-mini S&P 500 continuous contract (ES), five minute

The E-mini S&P futures made a downside opening gap on Aug 2, 2004, on terrorist

threats The market spent most of the day filling the gap.

FIGURE 3 EMOTIONS TRIGGER GAP

Source: TradeStation

Gap filled for a 61-point gain, or $305 per contract.

15:00 9:00 10:00 11:00 12:00 13:00 14:00

10/16/03

9,8009,7909,7809,7709,7609,7509,7409,7309,7209,7109,700

One day after the trade setup shown in Figure 1, the mini Dow contract

opened lower, setting up a long trade.

FIGURE 2 THE DAY AFTER

Source: eSignal

Trang 15

trading methodology, while

ama-teurs are constantly adjusting

Ignore the reasons for the gap

The size or cause of a gap has little

impact on whether or not it will be

filled Figure 3 shows an example

of emotions triggering an opening

price gap when, on Aug 2, the

market gapped down on the open

because the U.S government

issued a terror warning the

previ-ous day There were rumors of a

plan to blow up a large financial

institution

H o w e v e r, after a choppy first

half of the day, the market firmed,

shorts got nervous and started

cov-ering, and the gap was filled by

1:30 p.m ET for a 6.75point S&P E

-mini profit ($337.50 per contract)

Relax and trade

F i g u re 4 shows a 15-minute chart of

the September mini Dow future s

(YMU04) with an opening gap on

Aug 18 that did not get filled for

six trading days (Other opening

gaps occurred before price

eventu-ally filled the first gap.) On this day,

the mini Dow gapped up a modest

44 points prior to the release of some

economic numbers The pre-market

vol-ume was modest, between 30,000 and

70,000 shares for the key stocks, so the

a p p ropriate step was to short a

two-t h i rds-size positwo-tion on two-the open

The market rallied, sold off a little just

prior to the economic numbers, and then

shot higher once the numbers were

released Using the 1:1 reward/risk ratio

resulted in a 44-point stop The market

never retraced to the gap’s midpoint

level (where half the position could be

c o v e red), and instead rallied right

through the stop, producing a loss of

$220 per contract For a two-thirds

posi-tion (six contracts) the loss was $1,320

This move left an open gap below the

market The next day the market opened

modestly lower, triggering a long trade

that resulted in a quick $65-per-contract

profit ($585 total) The following day the

market opened 52 points lower and

filled the gap a few hours later for a

$ 2 6 0 - p e r-contract profit ($2,340) The

next day, the market gapped up 44

points, triggering a short trade that came

close to the stop-loss point, but

eventual-ly filled the gap for a $255-per-contract

profit ($2,295) All these gaps followedlight pre-market volume, so they wereexecuted with full positions

On Aug 22, 2003, Intel announced

“cautious upside earnings re v i s i o n s ”The market exploded to the upside andgapped right above key resistance Thetrade was to short the 62-point gap with

a full-size position Six bars later, the get was hit for a 62-point profit, or $310per contract ($2,790)

tar-During the afternoon session, the ket traced out a bear flag pattern Wi t hthe opening gap under the market stillunfilled, the trade was to place a sell stop

mar-at 9,392 to let the trend of the market tiate the trade based on a breakdown ofthe flag The entry stop was filled and therisk point for the trade was above intra-day resistance at 9,455.The target was theAug 18 gap at 9,304 The market spentthe rest of the day trending lower, fillingthe gap and resulting in an 88-point gain,

ini-or $440 per contract ($3,960)

A brief window of opportunityThe market’s nature is to prevent asmany people as possible from consis-tently making money, which is why it iscrucial for a trader to follow rules for

each type of trade setup

Gaps are the one moment of the ing day where everyone has to showtheir poker hand, and this creates a bigadvantage for short-term traders.Understanding the dynamics behindopening gaps is paramount to tradingthem successfully.Ý

trad-For information on the author see p 10.

Mini Dow September futures (YMU04), 15 minute

Gap of +62 pointsfills in 6 bars

Short break of bearflag Target is gapfrom 8/18

Gap of +44 points fills in 9 bars

Gap of -52 points fills in 9 barsGap of +13 points

fills in 1 bar

Gap on 8/18 of +44 pointsfills on 8/25

8 / 1 8 1 3 : 1 5 8 / 1 9 1 1 : 4 5 1 4 : 1 5 8 / 2 0 1 2 : 4 5 8 / 2 1 1 3 : 4 5 8 / 2 2 1 2 : 1 5 8 / 2 5 1 3 : 1 5 8 / 2 6

9,5009,4809,4609,4409,4209,4009,3809,3609,3409,3209,3009,280

The first opening gap on this chart — which remained unfilled for the next six days — set up a short trade that was stopped out for a loss Subsequent opening gap trades were more successful.

FIGURE 4 MULTIPLE GAPS

“Morning reversal strategy” by Bryan

C Babcook and Arthur Agnelli,May 2003, p 36

“Technical Tool Insight: Gaps,” April

Trang 16

System concept: Most traders are familiar

with the technical analysis axiom, “All gaps

are eventually closed.” A gap occurs when a

price bar’s high is lower than the previous low

or its low is higher than the previous high A

significant gap creates a void in which no

trades occur, as shown in Figure 1 An

“open-ing gap” occurs when price opens above the

previous high or below the previous low; such

gaps can be filled the same bar, in which case

no visible bar-to-bar gap (such as the one in

Figure 1) will appear on the chart

The idea that gaps are eventually closed

stems from the absence of trades within the

range of the gap Because there are no traders

who are holding positions within the gap zone

(some may have entered positions earlier in

the chart’s history), there is an absence of the

upside resistance that is typically caused by traders seeking to

exit at breakeven or a profit-target level Because of this lack of

resistance, price often moves sharply to close the gap when itfirst recovers and penetrates the gap zone This type of price

movement can also lead to the “islandreversal” pattern, which occurs when agap in one direction is followed by (afterone or more intervening bars) a gap in theopposite direction

This test is designed to see if the axiomregarding closing gaps holds water Thesystem tested here goes long the day after

a large gap down and holds the positionuntil price reaches the low of the barimmediately before the gap — i.e., whenthe gap is closed

This “system” is for experimental poses only The goal is to test the effective-ness of trading gaps in the simplest waypossible; no protective stops are included.Because of this, positions can be heldindefinitely and result in substantial draw-downs when gaps are never closed If youwanted to actually trade a gap-based sys-tem, you would most likely use a protec-tive stop to protect against these losses

pur-Rules:

1 Enter long on the open the day after a

down gap greater than the 20-bar age true range (ATR) is completed

aver-2 Place a limit order to sell the position at

the low price of the bar that

immediate-ly preceded the gap

3 The system will maintain multiple

E q u i t y Cash Linear reg

FIGURE 1 EQUITY CURVE

3/3/93 1/7/94 1/3/95 1/2/96 1/2/97 1/4/99 1/3/00 1/2/01 1/2/02 1/2/03Gap closer

FIGURE 2 SAMPLE TRADES

Source for all figures: Wealth-Lab Inc (www.wealth-lab.com)

Apple Computer (AAPL), daily

The system went long when Apple Computer gapped down more than 13 percent on

June 19, 2002 Price started moving in the direction of closing the gap, but another

down gap occurred on July 17, 2002, causing a new long position to be established.

The frequency of down gaps increased after the broad market topped out in early

2000 The system exposure (light green area) increased substantially after this point Note that many of these gaps are still open.

Trang 17

open long positions (see Figure 2).

4 Hold the position indefinitely until the gap is

closed and the limit sell is triggered

Money management:Risk 9 percent of account

equity per trade This level was chosen because

it was the largest position size that allowed all

gaps to be traded during our test period

Starting equity: $100,000 ($10

slippage/com-mission deducted per trade)

Test data: The system was tested on the Active

Trader Standard Stock Portfolio, which contains

the following 18 stocks: Apple Computer

(AAPL), Boeing (BA), Citibank (C), Caterpillar

(CAT), Cisco (CSCO), Disney (DIS), General Motors (GM),

Hewlett Packard (HPQ), International Business Machines

(IBM), Intel (INTC), International Paper (IP), JPMorgan Chase

(JPM), Coke (KO), Microsoft (MSFT), Sears (S), Starbucks

(SBUX), AT&T (T) and Wal-Mart (WMT)

Test period:January 1993 through January 2003

System results: A total of 62 gaps occurred during the 10-year

test period Of these, 50 (80 percent) were closed for a profit

The remaining 12 gaps were open at the end of the test period

The average profit for the closed gaps (which took, on

aver-Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts It is not meant to recommend or promote any trading system or approach Traders are advised to do their own research and testing to determine the validity of a trading idea Past performance does not

LEGEND: Net profit — profit at end of test period, less commission •

Exposure — the area of the equity curve exposed to long or short positions, as

opposed to cash • Profit factor — gross profit divided by gross loss • Payoff

ratio — average profit of winning trades divided by average loss of losing

trades • Recovery factor — net profit divided by max drawdown • Max DD

(%) — largest percentage decline in equity • Longest flat days — longest

period, in days, the system is between two equity highs • No trades — num

-ber of trades generated by the system • Win/Loss (%) — the percentage of

trades that were profitable • Avg profit — the average profit for all trades •

Avg hold time — the average holding period for all trades • Avg profit

(winners) — the average profit for winning trades • Avg hold time

(win-ners) — the average holding time for winning trades • Avg loss (losers) —

the average loss for losing trades • Avg hold time (losers) — the average

holding time for losing trades • Max consec win/loss — the maximum

number of consecutive winning and losing trades

LEGEND: Avg return — the average percentage for the period • Sharpe ratio

— average return divided by standard deviation of returns (annualized) • Best return — best return for the period • Worst return — worst return for

the period • % Profitable periods — the percentage of periods that were prof itable • Max consec profitable — the largest number of consecutive prof - itable periods • Max consec unprofitable — the largest number of consec - utive unprofitable periods

-Trading System Lab strategies are tested on a portfolio basis (unlessotherwise noted) using Wealth-Lab Inc.’s testing platform

If you have a system you’d like to see tested, please send the ing and money-management rules to editorial@activetradermag.com

trad-age, 100 trading days to close) was just under 11 percent Bycomparison, the average loss of the 12 gaps that are still open

is a sharp -32 percent, and the average number of trading daysthey have been open is about 350 (about one and a half years).That most of the gaps in the test portfolio within the past 10years have been closed reinforces the idea that gaps do have atendency to get filled — although it often takes a while.However, the damage done by the minority of gaps that didnot close wiped out most of the profits achieved from themajority of gaps that did close This leads to the conclusionthat trading gaps on their own entails significant risk

However, it is possible to combine gaps with other tradingtools and methods The old saying, “All gaps are eventuallyclosed,” may not be totally accurate, but knowing the odds aregood that a certain price target will be reached can play animportant role in a trading strategy.Ý

— Compiled by Dion Kurczek of Wealth-Lab Inc.

FIGURE 3 DRAWDOWN CURVE

P r o f i t a b i l i t y Trade statistics

D rawdown Avg loss (losers) %: - 3 1 8 0

STRATEGY SUMMARY

PERIODIC RETURNS

As more gaps were opened and more long positions established,

a large drawdown began in 2000.

Trang 18

System concept:The stock Trading System Lab (p 54)

fea-tured an experimental system designed to trade gaps The

intention was to go long on every down gap and hold the

position until the gap was closed (if it ever closed) This

pro-vides useful information about the dynamics of gap

behav-ior

However, it is not possible to hold a losing futures

posi-tion in a similar manner because the higher leverage in

futures results in losses of a much larger magnitude Taking

this into account, the futures system goes long right when

price is starting to fill a down gap The absence of resistance

in the price void of the gap should provide positive

momen-tum for a long trade Based on the results of the stock test, it

is likely most of the gaps will be filled

In addition, this system uses three different exits to

pro-tect capital while giving trades room to breathe The

strate-gy uses a breakeven stop entered soon after the trade is

prof-itable to protect against a reversal When the gap is not filled

and prices do not reach our breakeven level, we employ a

wide stop-loss order

The system should have a large number of winning and

breakeven trades, and a small number of large losses

Because of the high expected win-loss ratio, the strategy uses an

aggressive maximum risk setting (10 percent equity loss per

trade) All traders must weigh these considerations and mine their personal risk tolerance when deciding on the stop-

deter-loss and maximum risk levels

Rules:

1 A long entry setup occurs when there is

a down gap greater than the 20-bar age true range (ATR) Multiple open trades are acceptable

aver-2 Go long on a buy stop order at the high

of the down-gap bar plus one tick

3 Exit with a profit using a limit order at

the low of the bar that preceded the down gap

4 Place a stop-loss order below the entry

price that is three times the distance between the entry price and the profit target level

Note: Wait until the close of the entry bar

before placing the profit target and loss orders

stop-5 As soon as the contract closes with a gain

of at least one percent, place a breakeven stop to exit at the entry price.

Risk control and money management:

1 Starting equity: $100,000 Deduct $10

slippage/commission per contract (entry and exit)

2 The number of contracts to buy is

deter-mined by calculating the distance between the entry price and the initial stop-loss level Buy the number of contracts that results in a maximum loss

FIGURE 2 SAMPLE TRADES

Gold futures (GC), daily

Equity Cash Linear reg

FIGURE 1 PORTFOLIO EQUITY CURVE

8/16/93 7/4/94 6/2/95 5/1/96 4/1/97 3/2/98 1/3/00 1/2/01 1/2/02

Trading System Lab

FUTURES

Gap closer

Gaps in gold trigger two trades The green lines represent the entry points and the red lines

represent the profit-target exits Notice how prices gapped up to close the first gap down,

forming an island reversal The second gap also closed, but not before the trade was

stopped out Increasing the stop-loss distance would have turned this trade into a winner.

The equity curve exhibits some volatility, but also an overall upward bias and extremely low market exposure This is a result of the small number of trades, as well as their short holding periods.

Trang 19

LEGEND: Avg return — the average percentage for the period • Sharpe ratio — average return divided by standard deviation of returns (annualized)

• Best return — best return for the period • Worst return — worst return

for the period • % Profitable periods — the percentage of periods that were profitable • Max consec profitable — the largest number of consecutive profitable periods • Max consec unprofitable — the largest number of consecutive unprofitable periods

Test data: The system was tested on the Active Trader

Standard Futures Portfolio, which contains the

follow-ing 20 futures: DAX30 (AX), corn (C), crude oil (CL),

German bund (DT), Eurodollar (ED), Euro Forex (FX),

gold (GC), copper (HG), Japanese yen (JY), coffee (KC),

live cattle (LC), lean hogs (LH), Nasdaq 100 (ND),

natu-ral gas (NG), soybeans (S), sugar (SB), silver (SI), S&P

500 (SP) and10 year T-Notes (TY)

Test period: This test used ratio-adjusted data (from

Pinnacle Data Corp.) spanning August 1993 to

November 2002

Test results: There were a total of 69 trades during the

test period This was less than the number of gaps that

occurred, but because the system enters as price begins

to penetrate the gap, there could be setups that have not

trig-gered trades yet Eleven of the trades trigtrig-gered our breakeven

stop and were closed at the breakeven level Ten trades were

losers, while 48 were winners This confirms our expectation of

the system’s win-loss behavior

Counting breakeven trades as losers, the system had a

win-loss ratio of nearly 70 percent The average profit of winning

Trading System Lab strategies are tested on a portfolio basis (unlessotherwise noted) using Wealth-Lab Inc.’s testing platform

If you have a system you’d like to see tested, please send the ing and money-management rules to editorial@activetradermag.com

trad-Profitability Trade statistics