Gap Trading is a bit controversial since everyone has a view about how to trade what kind of gaps. Here is a article which seemed to explain in detail about one of the ways to trade Gaps.
The framework of the ‘rule’ has two phases:
1. The market generally will close at least 50% of an open-gap (i.e. an open that gaps above the previous close) in the first 60-minutes; and
2. If the market does not do this, we can expect a strong day in the direction of the gap.
The are a number of filters that I use:
* The setup does not work on every market. It works best in the S&P and 30-Year Bonds. I have not tried it on the 10-Year Notes and T-Bills. It does not work on Gold, and the Currencies.
* The open-gap must be at least mean +1 ATR of the current structure. If you are unfamiliar with Barros Swings, use a 40-day ATR.
* If at the end of 60-minutes, the market has not closed at least 50% of the open-gap but is trading near extreme closest to the 50%, I would wait another 30-minutes.
The tactics I use with the open-gap are many, especially when combined with some other tools:
* Market Delta Volume indications
* Market Profile ideas: open relationship with the previous day’s value area; the type of open; where we are trading relative to the open-range of 5, 30 and 60-minutes intervals.
* Larger time frame context: for example prior to the open-gap, have the market ranges been compressing (this makes a trend day more likely) or they have been experiencing above average range days (this makes a rotational day likely and therefore ‘fading’ is likely to succeed).
What is fading? This brings me to the two general strategies.
The first and most common is to fade the open-gap and the second is to ‘go-with’ with the open-gap looking for a trend day. By ‘fade’ I mean take a contra open-gap trade; by ‘go-with’ I mean take a position in the direction of the gap.
If I am fading a gap, I will usually take a position in the second 5-minutes. As a rule with an open gap, the market will spend the first 5 minutes moving in the direction of the gap. ‘Five minutes’ is not a fast and hard time but rather an indication of some time spent. Here Market Delta volume and Open-Range ideas are very useful.
Here’s an example for a ‘fade’ entry. Let’s say that:
* The context would favour a rotational day. And,
* The market gaps up and nearing the end of the first 5-minutes, we see Market Delta Volume signifying at least a potential short-term top.
* The market then closes below the low of first 5-minutes bar.
In this situation, generally, I’ll wait for a rotation back up to sell.As far as exit strategies for ‘the fade’ are concerned, here are some ideas:
* Stop: One place for the stop would be above the highs of the day plus filter
* Profit Target (core profit contract): a tick or two above the closing of the gap (if day-trading).
For trend days, if I were day trading, for core profit exits, I’d use a trailing stop and look to exit at 4:00 am EST – since a trend day usually closes in the extreme 25% of its range. Thus in an up day that has a range of 32 points, I’d expect the close to close within 8 points of the high.