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How a Basic Gap Buy Signal Is Established

A basic gap buy signal occurs when a market opens on a gap down and then comes back up to penetrate the previous day's low by a given number of price ticks. When this occurs you buy for a day trade. You exit your trade either at a fixed-dollar-amount stop loss, a stop loss below the low of the day when you are filled, or MOC (market on close).

How a Basic Gap Sell Signal Is Established

A basic gap sell signal occurs when a market opens on a gap up and then comes back down to penetrate the previous day's high by a given number of price ticks. When this occurs, you sell short for a day trade. You exit your trade either at a fixed-dollar-amount stop loss, a stop loss above the high of the day when you are filled, or MOC (market on close).

As you can see, the rules of application for the gap trade are very simple. And the application of this methodology is simple as well. Figures 12-5 and 12-6 show ideal buy and sell signals. Figures 12-7 and 12-8 show actual buy and sell signals.

It should be noted that in trading gaps use only the day session prices. I repeat: In determining whether a gap has been made or not, do not use the overnight or Globex data. Gaps are determined based on day session data only! This is very important. Buy on a penetration of this low by a given amount (penetration size)

ж Sell short on a penetration of this high by a given amount (penetration size)

Psychology of the Gap Trade

In the psychology of the gap trade is found the reason for its excellent ability to capture winning day trades. When a market opens on a down gap, traders often panic and sell out. If the market can absorb their selling and then move up high enough to penetrate the previous day's low, the sellers realize that they've made a mistake (oops, we've made a mistake) and enter their longs again. At the same time, buyers waiting for a sign that the opening down gap was a bogus sign of weakness enter the market and bid prices higher. The market then usually closes near its high for the day.

The psychology of the sell gap is similar, only in reverse. Sellers exit en masse to cover shorts and to buy into new longs on a gap higher opening, thinking that the gap up is a sign of strength. When it fails to materialize, they exit and push prices down sharply. The psychology of the gap trade is, therefore, one of panic selling and panic buying. Gaps are highly correlated with tops and bottoms to the extent that gap trades occur frequently at or near market bottoms, whereas sell gap trades occur at or near market tops.