Gap Trading: Trading With Probabilities

“Gap trading” is a simple and disciplined trading approach. When gap trading, you don’t need any indicators. You only need to find a market that has a price gap from the previous close to today’s open.

More often than not prices tend to move towards the direction of the previous close, presenting excellent trading opportunities.

In this article I want to show you some ideas how to trade them.

It’s All About Probabilities

Depending on where the market opens today in relation to yesterday’s close, we see either a full gap or a partial gap.

Scott Andrews from www.MasterTheGap.com has been doing some extensive research about the probabilities of a gap fill.

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The above picture shows the winning percentage for various gap opening scenarios for the e-mini S&P based on more than 2,150 opening gaps between 2002 and 2011.

In this graphic the historical win rate in the S&P 500 E-mini futures for each zone is shown and assumes you faded the gap at the open and held for gap fill (prior day close i.e. thick, yellow line) or until the end of the day if gap did not fill.

Let me explain the different gap trading zones:

All zones starting with “D” are gap trading zones after a “down day”, i.e. the previous day’s close was below the previous day’s open. Here are the different scenarios:

  • D-H (54% historical winning percentage). If today’s open is above yesterday’s high, then there’s a 54% historic winning percentage of prices moving to yesterday’s closing price.
  • D-HO (61% historical winning percentage). If today’s open is above yesterday’s open, but below yesterday’s high, then there’s a 61% historic winning percentage of prices moving to yesterday’s closing price.
  • D-OC (74% historical winning percentage). If today’s open is between yesterday’s open and close, then there’s a 74% historic winning percentage of prices moving to yesterday’s closing price.
  • D-CL (83% historical winning percentage). If today’s open is below yesterday’s close, but above yesterday’s low, then there’s a 83% historic winning percentage of prices moving to yesterday’s closing price.
  • D-L (64% historical winning percentage). If today’s open is below yesterday’s low, then there’s a 64% historic winning percentage of prices moving to yesterday’s closing price.

Scott identifies similar zones after an “up day”, i.e. the previous day’s close was above the previous day’s open. Here are the different gap trading scenarios after an “up day”:

  • U-H (65% historical winning percentage). If today’s open is above yesterday’s high, then there’s a 65% historic winning percentage of prices moving to yesterday’s closing price.
  • U-HC (85% historical winning percentage). If today’s open is above yesterday’s close, but below yesterday’s high, then there’s a 85% historic winning percentage of prices moving to yesterday’s closing price.
  • U-CO (74% historical winning percentage). If today’s open is between yesterday’s open and close, then there’s a 74% historic winning percentage of prices moving to yesterday’s closing price.
  • U-OL (65% historical winning percentage). If today’s open is below yesterday’s open, but above yesterday’s low, then there’s a 65% historic winning percentage of prices moving to yesterday’s closing price.
  • U-L (48% historical winning percentage). If today’s open is below yesterday’s low, then there’s a 48% historic winning percentage of prices moving to yesterday’s closing price.

Not All Gaps Are The Same

As you can see, opening gaps in general have a strong tendency to trade back to the prior day’s closing price (65-70%), but depending on today’s open in relation to the previous day’s open, high, low and close, sometimes the probabilities are higher than average.

You don’t have to trade every single gap – focus on the high probability gaps!

The name of the game is not trying to catch all of the winners, but rather to avoid most of the losers.

As an example, why do you think gaps in the U-L zone (bottom right of the Gap Zone Map – see above) show such a low historical win rate (48%)?

Scott Andrews believes it’s because gaps opening in this zone are catching traders positioned to the long side off guard, triggering many sell stops in the process. Plus, such an obvious reversal from the prior day surely attracts new short sellers who want to jump on board the beginning of a new potential trend.

Gap Trading In A Nutshell

When looking for gaps, obviously you want to exclude the “overnight session” and only focus on the “day session” of the markets.

ANY market and even stocks are suitable for gap trading. The above graphic shows the historic winning percentage of the e-mini S&P. As you can see, the odds are in your favor when trading gaps, but keep in mind that past performance in not necessarily indicative of futures results.

Pick the highest probabilities. As I said before: It’s not about trying to catch all of the winners, but rather to avoid most of the losers.

With that in mind, give gap trading a shot. You can do it with ANY charting software, since you don’t need any indicators or other fancy tools.

To learn more from Markus, please visit his blog at RockwellTrading.com.