Excerpted from How to Trade High Probability Stock Gaps — 2nd Edition:
We wrote this How To Trade High Probability Stock Gaps Guidebook shortly after we completed our ETF Gap Trading – A Definitive Guide. If you already own ETF Gap Trading – A Definitive Guide, you will see here that trading gaps on stocks is different than trading gaps on ETFs. Conceptually they are the same but when you get into the exact details and the trading execution of these details, a few things stand out:
- The size of the gap in stocks is very important. In trading ETF Gaps, the size of the gap does not make much of a difference in the overall returns. In stocks they do and we devote an entire section to it.
- The size of the limit order to buy or short a gap needs to be significantly larger in trading gaps in stocks than in trading gaps in ETFs.
Our research on stock gaps looked at a 12‐year period of time (2001‐2012) which is longer than the gap research that was published on ETFs. The reason for this is because the universe of ETFs became larger and grew rapidly beginning in 2006 and that’s where the testing started.
Before we move ahead, we’d like to reprint the introduction to the ETF Gap Trading – A Definitive Guide because we feel it is appropriate for you to have a longer term history of the value of trading gap reversals on multiple asset classes.
In the early 1980’s legendary researcher and professional trader Larry Williams published a commodity trading strategy that he named “OOPs.” The basic concept behind Larry’s research was that commodities that gapped lower (especially on Mondays) tended to reverse and move higher. He found they had statistical edges.
A few years later in 1990 after Larry published his research, an unknown (at that time) commodities trader by the name of Toby Crabel wrote a book titled Day Trading with Short Term Price Patterns and Opening Range Breakout. In his book, Crabel looked at many different price patterns, including gaps, and showed the historical returns from these patterns. When the book was published, I devoured it. I was still working for Donaldson Lufkin and Jenrette (DLJ) at the time and was making my way towards my goal of trading for myself. At that time there were few credible trading books and even fewer which backed their strategies with quantified results. For traders like me, Toby’s book was a gift from heaven. He statistically showed what many of us saw – pattern recognition worked and he had the statistics to prove it. Crabel went on to build one of the largest Commodity Trading Advisor (CTA) firms in the world with consistent low volatility returns for the past two decades using this research as his base.
I’m fortunate to have had a handful of conversations with both Larry and Toby especially in the 90s and I view them as incredible role models who paved the way for much of my thinking towards the markets. Both like to focus on trading on the opposite side of the crowd, both view risk management as a key role towards success, and most importantly both are incredibly disciplined in making sure that their research is backed by strong statistical test results.
In this Strategy Guide I’m going to take one popular strategy, “Trading Gap Reversals,” apply it to stocks and show how the stock gaps have performed from 2001‐2012. What you will see, just as Larry Williams and Toby Crabel saw over two decades ago in the commodities markets, is that Gap Reversals hold true in the stock market. There is strong statistical evidence that Gap Reversals is an excellent strategy that traders should seriously consider.
My research company looked at every stock gap over a twelve‐year period. This period includes the bull market years of 2003‐2006, 2007, 2009, 2010, and 2012, the bear markets of 2001‐2002 and 2008, and the sideways market of 2011. Three very different types of markets were looked at and you probably couldn’t have asked for a better time frame to see how well the strategy fared. We looked at higher gaps and lower gaps. We did this on hundreds of liquid stocks (every stock which traded on average at least 1,000,000 shares for the past 21 trading days). We’ll show you how all these gap set‐ups performed using many different exits including intraday exits (day trading), exits that closed above/below popular moving averages, exits that closed above/below popular indicators, and even stocks which simply closed higher the first day after entering the position.
What you will see throughout this research is that Stock Gap Trading with the inclusion of specific filters we introduced has had consistently positive returns in the test results over the past twelve‐year period of time.
Most trading books show a trade or two that follow such gaps, but stop there and say “trust us, this works”. Sometimes it does, but more times than not when tested it doesn’t hold up. What we are going to do now is look at every stock gap combined with a popular oscillator filter from 2001‐2012 and see how they have performed. By looking at all these set‐ups over a time period of more than a decade, we get to see statistically whether or not edges have existed and just how large those edges have been. Now let’s move to the research, first on the entire universe of liquid stocks which have gapped lower.
End of Excerpt.
If you would like to continue reading How to Trade High Probability Stock Gaps — 2nd Edition you can download the guidebook for free here to learn how to identify the best stock gap setups every single day, including how to select optimal entry levels and where and when to exit your positions.