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Variations on the Gap Trade Theme

While the gap trade method is a viable method for day trading in active and volatile markets, I have discovered and researched several variations on the gap trade methodology that can make a significant difference in the bottom-line results. They are discussed below.

Gap Size. The size of the opening gap is important. Larry Williams, my colleague, friend of many years, and originator of the gap trade method, has often quipped "the bigger the gap, the better the trade," and I certainly agree with him. Shown in Figure 12-9 is a comparison of gap size and average profit per trade for gap trades in S&P futures covering the period from April 1982 (the inception of futures trading) through January 1998. I'm certain you'll agree that this is a sufficiently lengthy test period in terms of statistical validation.

The gap size figures suggest, but do not conclusively confirm, that a larger gap size is preferable. They do, however, show that there is a tendency for higher opening gap sizes to produce a larger average profit per trade than smaller gap sizes. A more effective approach is to use a different-size opening gap for buy signals and for sell signals. Since markets are not linear, this makes a great deal of sense. By varying the parameters, you will be able to fine-tune the gap trade method for a variety of markets.

Gap Penetration Size. This variable is also important. It measures how much the market penetrates back into its previous daily range for buy and sell signals. In other words, a smaller penetration size will give more trades. However, is it possible that a larger penetration size will give fewer trades but with higher accuracy? Figure 12-10 gives us an idea of how penetration size is related to average profit per trade.

The optimum numbers for gap penetration size were 10 ticks for longs and 12 ticks for shorts. The results using these entry gap sizes were 62 percent and $455 average trade for the period from 1982 through 1998 in S&P futures.

Stop Loss Size. Stop loss size is also very important. Shown in Figure 12-11 is a tabular listing of stop loss size with average profit per trade in S&P futures. As you can see, a larger stop loss is preferable for higher accuracy.

Period of Gap Comparison - Multiple-Day Gap Signals

I am about to make a major change in the gap concept as presented heretofore, so hold on to your hat, since you'll need to have your thinking cap on for this one. While we know that the gap trade as I've discussed it so far is a good method for day trading, there is a variation on the theme of the gap trade that you may wish to consider. Consider the fact that a gap can be referenced back to the previous day or to any number of days back.