How To Fade Gaps
Today’s article will be a combination of a reader’s email and my response.Â
Given that the majority of what I consider to be the best trades from recent
sessions (always my favorite regardless of market conditions) are
Fade The Gap trades on the opening, I
figured not only was a response in order, but also sharing it with all the
readers of this column. I trust you will find it helpful.
1. Fading the Gap on 4/24/03, I sent you an
email asking for clarification on fading the gap, and you did so in your 4/25
column. Because fading the gap is such an important trading tool, I d like to
suggest some even further clarification:
   a.  The Trigger: you clarified that the trigger is typically the
opening price. You then went on to state that a break above/below is usually
the catalyst . In the case of your AMZN example, you noted that the price
traded up a little higher, then came right back through the opening price .
 That’s where I’m confused. I first assumed the break above/below the opening
price meant the very first price either direction from the opening price.Â
However, when you explained that the break was apparently when the price came
back through the opening price, I was confused as to what a break is.
Here’s what I’m assuming, so whether my inference is
correct or not, you might want to clarify this to readers:Â I’m assuming that a
break is when the price first trades the direction of the gap (i.e., toward a
closing of the gap). For example, if the price opened up, then if the
first few trades continued higher from the opening price, no break had
occurred yet. Rather, only if/when the price were to trade lower than
the opening price (i.e., toward a closing of the gap) would the break
have occurred. If this what you mean?
Fading the gap has a couple of different guidelines, and as most things with
trading, the best guideline is that good old gut feel that comes with experience
and seeing these set-ups over and over again. However, nonetheless, the
‘objective’ rules are thus:
-Â The ‘break’ that the reader refers to is a break of the opening low (from
gap up) and break of the opening high (from gap down). For instance, last week
Forest Labs (FRX) gapped down something like
$9 (10%) on the opening. If my memory serves me correctly the opening price was
54.10. The next few trades were down to 54.08, 54.07 for quite a few shares
(several large trades), then suddenly it trades back at 54.10 and most
importantly the offer then went to 54.25. The market looked like this:
54.08 x 54.25
That was the trigger. A print (trade) back through the opening low (open
price) and an indication that
FRX was under some good buying pressure.Â
(Unfortunately, Nasdaq stocks typically do not exhibit this type of ‘spread’
market which I have come to rely upon as trigger.)Â After being filled at 54.25
the market then went:
54.25 x 54.50
It then went on to print the 54.50 and even momentarily went offered at
54.75. However, the key (like all exits in HVT) was the slowing momentum. Not
only did nothing ever trade above 54.50 despite the offer at 54.75, but it was
occuring on large blocks. That was the signal to head for the door (market
order), the fill was at 54.50. Guess where the next trades went off? 54.10,
right back to the opening price and a price which would have resulted in a
loss. Greed, never let it get the best of you.
Assuming my explanation above is what you intend as the definition, then it
might also be useful to explain to readers whether a break can be assumed to
have occurred even before trading back down through the Open (in our AMZN
example). For example, let’s say that in our AMZN example the price immediately
trades up several 1-minute bars and then reverses back down toward the
Open (and, hence, toward the gap). Do the pros consider the entry for a fade to
begin at this higher price or do they consider a fade not to be a good
probability entry unless/until the price comes all the way back down to the
opening price and then breaks down below the opening price for the first
time?
 This scenario (pulling the trigger before the opening price is taken out) is
perfectly fine. Typically it is the same premise as any good HVT trade. Are
the stochastics oversold/overbought? Is the momentum slowing? Are the S&P’s
beginning to tuen in the direction that you wish to place a trade? If these
parameters are met, you can consider an entry point. If the opening price is
taken out in the process, all the better.
    b.  With-Trend Versus Contra-Trend Gaps A subject
that would also be useful to your readers, I believe, is whether the
fade-the-gap phenomenon that is so lucrative to so many pros is more viable when
the gap is in the direction of the prevailing general trend from the
previous day or counter to that trend. For example, if the Open today
were to be below the low of the previous day, would the
expectation of a nice fade-the-gap trade be as good as would be the case if the
Open today was above the previous day s low (again assuming that the
close the previous day was at or near its low)?
Yes, naturally if you can get the S&P’s at your back that is very helpful. The
trend is not important, what is is trying to time your entry with a move in the
S&P’s (when they have pulled back or rallied to the moving average and are
beginning to resume their 1-minute trend).
I trust that this exchange has proven useful. I encourage emails like this,
not only do they help clarify questions, but are great for coming up with useful
columns (especially during the summer, hint hint)Â
| Support/Resistance Numbers for S&P and Nasdaq Futures |
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Mark your calendars! This Tuesday, June 24th, I will be interviewing someone
who plays an integral part in my day to day trading, Ben Lichtenstein. Ben
calls the action each day from the S&P 500 pit on the
CME. I can tell you this, I feel lost when I do not have him on
while trading. Join myself and Ben as we talk about the current state of the
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As always, feel free to send me your comments and questions.
Dave