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The Best Gap Trades

You might think that the best gap trades (by which I mean most profitable and most reliable) occur consistent with the extant trend. This is not necessarily true. Some of the best buy gap trades occur in bear markets as short covering panics occur. Some of the best sell gap trades occur in bull markets as traders take profits en masse.

Gap trades have had a noteworthy history. They are reliable and often profitable because they're based on the essential principle that underpins all trading psychology. As long as traders trade markets and as long as traders are human, gap trades will continue to work. And if they stop working, then I'm certain other psychologically based trading patterns will take their place.

Here is a review of the basic gap trade rules:

ж To trade gaps the market must open either above the previous daily high or below the previous daily low by a given number of ticks or points.

- ж A gap buy signal is generated once the market has opened on a

gap lower and then comes back up to penetrate the previous daily low by a given number of ticks.

ж A gap sell signal is generated once the market has opened on a gap higher and then comes back down to penetrate the previous daily high by a given number of ticks.

ж Gap buy or sell trades are closed out at the end of the day or at a predetermined stop loss.

Pragmatic Considerations in Trading Gaps

While theory is one thing, reality is another. The reality of gap trading is that it is not appropriate in all markets and it is not appropriate at all times. The fact is that the two most important day-trading criteria must be met if the gap is to be used effectively: volume and volatility. Gap trades based on my rules can work well in markets such as S&P 500 futures, but they are doomed to failure in a market like oats, where trading volume is thin and where volatility is minimal (most of the time).

Another practical consideration is the use of stop losses. As you well know, there are three schools of thought on stop losses:

1. The best stop loss to use in a market is a risk management stop. In other words, risk a certain amount of money on each trade, and if the stop is hit, then exit.

2. A stop loss should be determined on the basis of your system and not on the basis of dollar risk.

3. A trailing stop loss should be used once a given profit target has been hit in order to preserve the profit.

These, then, are the basic stop loss strategies. Naturally, there are variations on the theme; however, my research has clearly indicated the following best strategies for gap trades as well as for most day trades.

ж A dollar risk management stop loss is best as an initial stop.

ж Once a given profit level has been achieved, a trailing stop loss is effective.

ж The trailing stop loss must be a large one. In other words, you must be willing to risk up to 90 percent of your open profit, or you will be stopped out repeatedly.

ж Small stop losses will work against you in gap trades, and in fact, a small stop loss will work against you in virtually all types of trading other than "scalping."

In some cases, holding a gap trade overnight may prove more profitable than exiting at the end of the trading session. But note that the trade would then no longer be considered a day trade. This method will be discussed later in this chapter.