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Gap Methods for Day Trading

Take a straw and throw it up into the air, you shall see by that which way the wind is.

john selden

One of the more effective and specific methods of day trading is to use an opening price gap as the first indication of a possible trade. The basic method for trading, based on opening price gaps, has already been discussed in detail in my book The Compleat Day Trader. My discussion in this chapter will briefly review the basic gap method and will give you an additional gap method that is a variation on the theme.

A Day Trader's Dream

My years as a trader and market analyst have convinced me that the more input a trader has in the formation of a trading decision, the more likely that the decision will be wrong. While this may not sound right, the fact is that it is right. Traders cannot help but have their wishes, emotions, expectations, fears, and dreams interfere with their decisions. Hence, the more a trader thinks about a trade - the more a trader analyzes a trade - the greater the probability that the trade will be a loser. I do not mean to denigrate the importance of the trader, yet facts are facts.

Unless you're an exceptional trader, you'll find that the more you spend in thought, the less you reap in profits. Traders don't need complicated systems; they need simple systems that don't require a great deal of judgment or thought. This is especially true of day-trading methods.

Some day traders are addicted to their quote screens, watching every tick as if their lives depended on it. And unfortunately it often does! My point of view is that if you want to sit and watch every price tick, you ought to just buy or lease an exchange membership and trade from the floor.

I believe that day trading should be a simple proposition, reasonably mechanical, and as objective as possible. Hence, the gap trade and its variation (to be discussed in this chapter) is the day trader's dream.

Oops!

The gap trade is a method that fits all of the important requirements of a day trader. I was originally introduced to the gap trade by Larry Williams, who deserves all of the credit for it. (Larry called it the "oops" signal for reasons that I'll explain later.)

The rules of application are simple. But before detailing them I'll define what I mean by a gap. In this case we are dealing with an opening gap, which is the first condition for entering a gap trade.

1. Opening gap higher (gap up). This occurs when the opening price for the day is higher than the high of the previous day. See Figure 12-1 for an ideal representation of the gap higher open. See Figure 12-2 for examples of gap higher openings. Note that when I refer to the "opening," I mean the first "print" price or the officially defined opening as determined by the given exchange.

2. Opening gap lower {gap down). This occurs when the opening price for the day is lower than the low of the previous day. See Figures 12-3 and 12-4. Again, by the "opening" I mean the first "print" price or the officially defined opening as determined by the given exchange.

The opening gap up sets the precondition for a short sale. The opening gap down sets the precondition for a buy. Note that a gap up opening does not immediately give a sell short signal. It merely sets the first condition for a sell signal. A gap down opening does not immediately signal a buy. It merely sets the first condition for a buy signal.