Using Gap Zones to Create a Profitable Strategy

for the Opening Gap

Scott Andrews

Disclaimer This material is intended for educational purposes only and is believed to be accurate, but its accuracy is not guaranteed. Trading and investing has

large potential rewards and large potential risks. You must be aware of, and fully understand, these risks and be willing to accept them in order to

invest in equity, futures, options, currencies and other financial markets. Do not trade with money that you cannot afford to lose. This material is neither

a solicitation nor an offer to buy or sell equities, futures, options, or currencies. No representation is being made that any account will or is likely to achieve profits or losses similar to those discussed. The past performance of any trading system or methodology is not necessarily

indicative of future results. Use this information at your own risk!

Copyright NoticeAll materials contained in this presentation are protected by United States

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Master The Gap, Inc.

Overview

• The Basics, Promise & Dilemma• Solution: Gap Zones• The Math• Two Weeks in the Life of a

“Gapper”• Summary • Q & A

Definitions

• Gap – difference between the prior day close and next day’s opening price (regular session / pit hours).

• Fade – to trade in the opposite direction of the gap.• Gap Fill – when price retraces from the opening back to the prior

day’s close.• Win Rate – percent of gaps that, if faded at the open, filled the gap

or could have been exited at the end of the day for a profit.• Profit Factor – the ratio: (profits from winners) / (losses from losers)

measures the historical profitability of a given setup. This is more important than “win rate.”

• “Gapper” - a unique individual that has evolved beyond his/her trading peers by recognizing the superior return on time, effort and capital of the "gap fade." This elite trader can be recognized by his/her enviable lifestyle & finances.

Why I Love Gaps1. Gaps have an inherent bias and edge (>70% win rate).

2. They occur frequently (three to four tradable gaps per week in the S&P).

3. It's an easy trade to learn and play.

4. I can prepare in about 15 minutes before open.

5. I can trade them without charts and from anywhere.

6. Getting filled with minimal slippage is not an issue.

7. The entry and target are pre-defined so I don't have to manage the trade.

8. My risks are limited and controlled - no overnight risk.

9. They work in bull and bear markets equally well – no need to predict the market’s next move.

10. They occur in most asset classes and can be traded using stock, options, and futures

contracts.

11. I can grow my account significantly with this single, simple setup & one market.

12. Understanding the bias of the market before and after the gap fills, provides a trading edge for

the rest of the day while also helping optimize my entries on swing and position trades.

The Promise of Gap FadingYear Number of Gaps Win %

2008* 79* 72.2%

2007 225 64.9%

2006 200 72.5%

2005 196 71.4%

2004 213 72.3%

2003 211 75.4%

2002 229 73.4%

2001 208 74.0%

2000 223 73.5%

1999 236 75.9%

1998 226 73.0%

Total: 2,246 72.4%* January 1 - April 30, 2008

“Win %” is based upon hypothetically fading opening gaps > 1 point in the E-Mini S&P 500 futures, 1998-2007, using no stop, targeting prior close, exiting end of day if gap did not fill. This not a recommended strategy.

The ParadoxYear Profit Factor 2008* 1.24

2007 0.71

2006 1.01

2005 1.05

2004 1.11

2003 1.30

2002 1.14

2001 1.16

2000 0.94

1999 1.14

1998 1.06

Average: 1.08 (yawn)• January 1 - April 30, 2008

Profit factor = total profits of winners / total losses from losers

Though an extremely high win rate, the profits from the winners barely exceed the losses from the losers.

Though an extremely high win rate, the profits from the winners barely exceed the losses from the losers.

The DilemmaStop As % of

Gap Size% Win Average

Win/Loss RatioProfit Factor

25% 21.4 3.49 0.95

50% 36.0 1.80 1.01

75% 47.0 1.18 1.05

100% 53.7 0.91 1.06

125% 59.0 0.73 1.05

150% 61.8 0.64 1.04

175% 64.7 0.57 1.05

200% 66.1 0.53 1.03

Note: 1998 – 2007, E-Mini S&P 500 futures.

Using small stops does not improve profitability due to the reduction in win rate.

Using small stops does not improve profitability due to the reduction in win rate.

The key to making money fading opening gaps is…

SELECTION

Filter by “Size of Gap”?

Fading 1- 3 point gaps at the open, using a 6 point stop: – 78.0 % filled or finished profitable (687/881)– Profit factor:  1.17

Fading gaps > 10 pts at the open, using a 6 point stop:  – 37.5% filled or finished the day profitable (91/243) – Profit factor = 1.17

Note: based on E-mini S&P 500 futures, 1998 - 2007

Gap size is not correlated with profitability. Gap size is not correlated with profitability.

A Solution…

“Gap Zones”

Definition: location of the gap

relative to the prior day’s key

price levels: Open, High, Low

and Close.

High

Close

Open

Low

“Location, location, location”… applies to gaps too! “Location, location, location”… applies to gaps too!

Why Gap Zones Work

They inherently incorporate:

• Support and resistance• Short term trend• Gap size• Trader psychology

High

Close

Open

Low

Gap Zone AreasPrior Day Potential Next Day Gap Areas

Above the high

Below the high & above the open or close

Between the open and close

Below the open or close& above the low

Below the low

Gap Fade Win %

All gaps > 1 point = 72.4 %

“Win %” is based upon hypothetically fading opening gaps > 1 point in the E-Mini S&P 500 futures, 1998-2007, using no stop, targeting prior close, exiting end of day if gap did not fill. This not a recommended strategy.

Gap Fade Win % By ZonePrior Day Historical Win Rate

69%

76%

75%

76%

63%

“Win %” is based upon hypothetically fading opening gaps > 1 point in the E-Mini S&P 500 futures, 1998-2007, using no stop, targeting prior close, exiting end of day if gap did not fill. This not a recommended strategy.

Direction of Prior Day Should Be Considered Too

Open

Close

Close

Open

Prior day “direction” incorporates the short term trend.Prior day “direction” incorporates the short term trend.

The Math…

Gap Fade Win % By Gap ZoneWin % Prior Day

59%

66%

75%

78%

65%

“Win %” is based upon hypothetically fading opening gaps > 1 point in the E-Mini S&P 500 futures, 1998-2007, using no stop, targeting prior close, exiting end of day if gap did not fill. This not a recommended strategy.

Prior Day Win %

71%

82%

75%

72%

54%

Let’s Compare Similar Gaps in Four of the Zones…

Zone BZone A

Zone C Zone D

Test Scenarios

• 3-7 point gaps• Four zones: 2 long & 2 short strategies• Test 3 targets: exit end of day, gap fill, & 3 points beyond• Test “no stop” & 6 point stop• Compare win rate • Compare profit factor (pf)

Scenario #1: No target, no stop, exit EOD

A

C D

B

Baseline: 48% win rate, 1.0 pf (all zones)Baseline: 48% win rate, 1.0 pf (all zones)

48% win.73 pf

53% win1.27 pf

42% win.51 pf

52% win.98 pf

Best “fade” candidate

Best “go with” candidate

Scenario #2: Target gap fill, no stop

A

C D

B

Baseline: 71% win rate, 1.05 pf (all zones)Baseline: 71% win rate, 1.05 pf (all zones)

65% win.87 pf

76% win1.11 pf

68% win.84 pf

55% win.75 pf

Historicallyprofitable even withno stop

Scenario #3: Target gap fill, 6 pt stop

A

C D

B

Baseline: 61% win rate, 1.14 pf (all zones)Baseline: 61% win rate, 1.14 pf (all zones)

59% win1.22 pf

68% win1.33 pf

55% win.85 pf

48%.85 pf

Using a stop made this a viable fade candidate

Getting very interesting…

Scenario #4: Target 3 pts past gap fill, 6 pt stop

A

C D

B

Baseline: 48% win rate, 1.09 pf (all zones)Baseline: 48% win rate, 1.09 pf (all zones)

49% win1.15 pf

58% win1.52 pf

36%.67 pf

41%.71 pf

Now we’retalking!

YUCKYUCK

BLUD!(below low of up day)

What Is Obvious? Scenario #1No target, no

stop, exit EOD

Scenario #2Target gap fill, no stop

Scenario #3Target gap

fill, 6 pt stop

Scenario #4Target 3 pts beyond gap fill, 6 pt stop

All Zones 48% win1.0 pf

71%1.05 pf

61%1.14 pf

48%1.09 pf

Zone A 48% win.73 pf

65%.87 pf

59%1.22 pf

49%1.15 pf

Zone B 53% win1.27 pf

76%1.11 pf

68%1.33 pf

58%1.52 pf

Zone C 42% win.51 pf

68% .84 pf

55%.85 pf

36%.67 pf

Zone D 52% win.98 pf

55%.75 pf

48%.85 pf

41%.71 pf

Most zones have a bias to fill, but some do not.Most zones have a bias to fill, but some do not.

Scenario #1No target, no

stop, exit EOD

Scenario #2Target gap fill, no stop

Scenario #3Target gap

fill, 6 pt stop

Scenario #4Target 3 pts beyond gap fill, 6 pt stop

All Zones 48% win1.0 pf

71%1.05 pf

61%1.14 pf

48%1.09 pf

Zone A 48% win.73 pf

65%.87 pf

59%1.22 pf

49%1.15 pf

Zone B 53% win1.27 pf

76%1.11 pf

68%1.33 pf

58%1.52 pf

Zone C 42% win.51 pf

68% .84 pf

55%.85 pf

36%.67 pf

Zone D 52% win.98 pf

55%.75 pf

48%.85 pf

41%.71 pf“BLUD” zone: Below Low of Up Day

Tip: Don’t Fade da’ BLUDs!

Two weeks in the life of a “gapper”…

How I Trade Gaps• Direction: mostly "fades" – though I do have a couple "go with" signals

• Pre-market Filters: primarily on where the gap opens (i.e. gap zone)

• Gap Size: totally dependent upon the zone

• Decision Time: based upon where prices are trading at 9:25 am ET

• Position Size: one contract for every $10,000 of equity

• Risk Management: if I’ve identified one or more risk factors, then I reduce my position size

• Stops: based upon points or a percentage of the gap amount, optimized by zone. I use a time-stop for some zones

• Targets: before, at gap fill, or beyond gap fill, depending upon the zone

• Entry Technique: at open (9:30 ET) using a market OCO (“One Cancels Other”) bracket order

• Exit Technique: at my target or stop, or end of day if neither hit. I never hold overnight. I manage some positions intraday.

Monday, April 7, 2008

Gap: up 9.5 pts

Zone: below high & above open of prior “down” day

Action: half size short at open

Result: -6 pts ($300) per contract

Time in trade: 3 hr, 25 min

Tuesday, April 8, 2008

Gap: down 7.25 pts

Zone: below low of prior “down” day

Action: no trade

Result: missed a winner

Wednesday, April 9, 2008

Gap: down 2.25 pts Zone: below close &

above open of prior “up” day

Action: short half size (“go with” trade) at open

Result: +3 pts ($150) per contract; scaled out +2.25, +3, +5

Time in trade: 28 min

Thursday, April 10, 2008

Gap: down 3.5 pts

Zone: below close & above low of prior “down” day

Action: long at open

Result: +6.45 pts ($322) per contract, scaled out: +6 and +8.25 pts

Time in trade: 1 hr, 46 min

Friday, April 11, 2008

Gap: down 16 pts

Zone: “BLUD” - below low of prior “up” day

Action: no trade

Result: good call

Monday, April 14, 2008

Gap: down 1.75 ptsZone: below close of

prior “down” dayAction: half size long

at openResult: closed at end

of day for -2 pts ($100) per contract

Tuesday, April 15, 2008

Gap: up 7 pointsZone: above high of prior

“down” dayAction: short at openResult: +4.3 pts ($215)

per contract; scaled out +4, +6, and +5 pts

Time in trade: 1 hr, 29 min

Wednesday, April 16, 2008

Gap: up 11.25 pts

Zone: above high of prior “down” day

Action: half size short at open

Result: stopped for a full loss (-6 pts) ($300) per contract

Time in trade: 1hr, 25 min

Thursday, April 17, 2008

Gap: down 8.75 ptsZone: below close, above

open of prior “up” dayAction: half size,

discretionary (no signal) long at open

Result: +5.33 pts (+$266.5) per contract (scaled out: +6, +3, and +8)

Time in trade: 6 hr, 6 min.

Friday, April 18, 2008

Gap: up 19.75 pts

Zone: above high of prior “up” day

Action: no trade

Result: good call

Summary

• The “gap fade” is a simple trade & a great

foundation for a trading plan

• Know the zone!

• It pays to be picky

• Don’t leave money on the table - know which

ones to close before or beyond gap fill