Morning gap strategies for trading stock gaps

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Morning Gap Strategies

Having trouble with those irritating morning gaps? You're not alone. Many of us spend hours working on new setups, only to watch them go up in smoke overnight. But there's no need to throw out all of your hard work just yet. You can do a quick analysis, adjust your trading strategy and get into a good position well after the crowd pulls the trigger on a gap play.

Many traders still place market orders before the open and walk away. Unfortunately, this is a sucker move that yields the worst fills imaginable. Take a few extra minutes to plan your gap entry, and you'll get much better prices. No, this isn't a daytrading column, although it will benefit anyone who plays in the intraday markets. It's for swing traders trying to fine-tune their entries and get positioned where they can take home the most money. Here are some strategies you can use.

Stand aside at the open, and use the third-bar swing to find the best gap entry. This is a dependable reversal or expansion move on the five-minute chart, occurring 11 or 12 minutes into the new trading day. This phenomenon is a relic of the old 15-minute quote delay. In past years, painting the tape before retail investors could access stock prices ensured a few extra pennies for market insiders. Because retailers were the last "paper" in the door, natural forces would then take over and trigger reversals or breakouts. Although real-time market access has grown substantially, this third-bar swing still shows its face on many days.

Let the stock draw the first three five-minute bars, and then use the high and low of this "three-bar range" as support and resistance levels. A buy signal issues when price exceeds the high of the three-bar range after an up gap. A sell signal issues when price exceeds the low of the three-bar range after a down gap. It's a simple technique that works like a charm in many cases. If you use this technique, though, a few caveats are in order to avoid whipsaws and other market traps. The most common is a first swing that lasts longer than three bars. If an obvious range builds in four, five or even six bars, use those to define your support and resistance levels. Also consider the higher noise level in five-minute charts. A breakout that extends only a tick or two can be easily reversed and trap you in a sudden loss. So let others take the bait at these levels, while you find pullbacks and narrow range bars for trade execution.

Gap location is more important than the gap itself. Does the opening bar push price into longer-term support or resistance? A strong up gap may force a stock through several resistance levels and plant it firmly on top of new support. Or it can push it straight into an impenetrable barrier, from which the path of least resistance is straight down.

Three-bar range support and resistance often need to complete a testing pattern before they will yield to higher or lower prices. This comes in the form of a small cup and handle, or an inverse cup-and-handle pattern. Simply stated, price reverses the first time it tries to exceed an old high or low, but succeeds on the subsequent try.

Price gaps generate other action levels as well. The most obvious is the support line in an up gap (or resistance line in a down gap). We'll call these "reverse break" lines. Violation of the reverse break can trigger price acceleration toward the gap fill line. These market mechanics make perfect sense: everyone who entered a position in the direction of the gap is losing money once price moves past the reverse break line.

The gap fill line marks support in an up gap and resistance in a down gap. In other words, the odds favor a reversal when price reaches it. Paradoxically, this is a terrible place for swing traders to enter new positions. The reverse break line will resist price from re-entering the three-bar range. In fact, price bouncing like a pinball from the fill line to the reverse break line and back to the fill line sets off a powerful trading signal in the opposite direction. It predicts the demise of the gap and a significant reversal.

The flip side of this reversal is a failure of a failure signal. In other words, price overcomes resistance at the reverse break line and retests the high of an up gap (or low of a down gap). The ability of price to retest these levels issues a strong signal to take positions in the direction of the gap.

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