Using Historical Probabilities

to Trade the Opening Gap

Scott Andrews
Hosted by Hamzei Analytics
November 10, 2010

Copyright 2010, Master The Gap, Inc.

 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 2010, Master The Gap, Inc.

 Agenda
Your Trading Style

The Basics

How I Trade Gaps

Gap Zones

Entries, Targets, & Stops

For More Info...

Copyright 2010, Master The Gap, Inc.
 Trading Style:
Discretionary vs. Probability-Based
Decision
Process Description Advantages Disadvantages

Selection, entry,
targets and stops Can be difficult to interpret
Probability- Minimizes emotion
are guided by conflicting data
Based historical Augments lack of experience
Access to reliable data/research
probabilities.

Decisions are Basic can be learned and applied Can take many years to achieve
based upon quickly consistent profitability
Discretionary interpretation of
indicators and Appeals to independent nature of Difficult to discern excellence
price action. many from random results

Which
Whichstyle
stylewould
wouldMalcolm
MalcolmGladwell
Gladwellchoose?
choose?
(author
(authorof
ofOutliers)
Outliers)

Copyright 2010, Master The Gap, Inc.

 What is a Gap?

The most
The most common
common definition
definition is
is the
the
difference between
difference between
a security's
a security's opening
opening price price and
and its its day
prior
prior day/session closing price.
closing price.

This difference shows up visually on a price

This difference
chart as anshows up visually
open space on a price
or gap.
chart as an open space or gap.

Copyright 2010, Master The Gap, Inc.

What Does a Gap Look Like?

GAP

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Example of Gap: 5 Min Chart

Next day
opening price
(9:30 am ET) Price retraces
& fills gap

Prior day
closing price
(4:15 pm ET)

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More examples of gaps

(see charts)

Copyright 2010, Master The Gap, Inc.

 Fade the Gap
The Easiest Trade of The Day

Gap fades have an inherent bias & edge. (>70% fill by end of day)*

Can prepare in minutes before opening bell.

Pre-defined entry, target and stop no need to time the entry or exit

Risks are limited and controlled - no overnight risk.

They work in bull and bear markets no need to predict the

markets next move (market neutral).
(* based upon hypothetically fading opening gaps > 1 point in the E-Mini S&P 500 futures, 1998-2009,
targeting prior close, exiting end of day if gap did not fill. This not a recommended strategy. )

Index
Indexfutures
futures(S&P,
(S&P,Dow,
Dow,Russell,
Russell,Nasdaq)
Nasdaq)are
areideal
idealgap
gap
trading
tradingmarkets
marketsdue
dueto
toliquidity,
liquidity,reversion
reversionbias,
bias,&&ease.
ease.
Copyright 2010, Master The Gap, Inc.
 Key Terms
u Fade: to trade in the opposite direction of the gap

u Gap Fill: when price retraces from the open (9:30 am ET)
to the prior day's closing price (4:15 pm ET)

u Win Rate (%): percent of opening gaps that, if faded at the open,
fill the gap or end the day profitable*

u Profit Factor = hypothetical gross profits from winning trades*

-------------------------------------------------------------
hypothetical gross losses from losing trades*

**Unless
Unlessnoted
notedotherwise,
otherwise,all
allresearch
researchshown
shownininthis
thispresentation
presentation
isisbased
based upon hypothetically trading the openinggap
upon hypothetically trading the opening gap
from
from 1998 2009, including commissions, but not accountingfor
1998 2009, including commissions, but not accounting for
any potential slippage or missed fills.
any potential slippage or missed fills.
Copyright 2010, Master The Gap, Inc.
The Paradox of Gap Fading
Year Profit Factor
2009 1.20
2008 0.90
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:
1.06 (yawn)
Though
Thoughananextremely
extremelyhigh
highwin
winrate,
rate,the
theprofits
profitsfrom
* Profit factor = total profits of winners / total losses from losers
from
the
thewinners
winnersbarely
barelyexceed
exceedthe
thelosses
lossesfrom
fromthe
thelosers.
losers.
Copyright 2010, Master The Gap, Inc.
 The Stop Dilemma
Stop As % of Win % Average Profit Factor
Gap Size Win/Loss Ratio

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

Using
Usingsmall
smallstops
stopsdoes
doesnot
notimprove
improve
profitability
profitabilitydue
dueto
tothe
thereduction
reductionin
inwin
winrate.
rate.
Copyright 2010, Master The Gap, Inc.
The key to making money
fading opening gaps is

SELECTION

Copyright 2010, Master The Gap, Inc.

 How I Trade Gaps

1. Focus on SELECTION

2. Fade the open

3. Hold for gap fill or beyond

(rarely scale out prior to fill)

4. Use a LARGE enough stop to let

probabilities work (~30% of 5 day ATR)

Copyright 2010, Master The Gap, Inc.

Selecting Gaps To Trade

Copyright 2009, Master The Gap, Inc.

 Gap Zones
High
Definition: Close

Location of the opening price

gap relative to the prior days
key price levels:
Open, High, Low & Close
Open

Low

Location,
Location,location,
location,location
locationapplies
appliesto
togaps
gapstoo!
too!
Copyright 2010, Master The Gap, Inc.
 Why Gap Zones Work
High
They inherently incorporate: Close

Proven support & resistance

Short term trend
Gap size
Trader psychology
Open

Low

Copyright 2010, Master The Gap, Inc.

 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.
Copyright 2010, Master The Gap, Inc.
 Gap Fade Win % By Zone
Prior 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.
Copyright 2010, Master The Gap, Inc.
 Direction of Prior Day
Should Be Considered Too

Open Close

Close Open

Prior
Priorday
daydirection
directionincorporates
incorporatesthe
theshort
shortterm
termtrend.
trend.
Copyright 2010, Master The Gap, Inc.
 Gap Fade Win % By Gap Zone
Win % Prior Day Prior Day Win %

60% 68%

62% 81%

77% 75%

77% 67%

66% 55%
Win % is based upon hypothetically fading opening gaps > 1 point in the E-Mini S&P 500 futures, 1998-2009,
targeting prior close, exiting end of day if gap did not fill. This not a recommended strategy.
Copyright 2010, Master The Gap, Inc.
Tip: Avoid Gaps That Open
Below the Low of an Up Day
Prior Day

AVOID!

BLUD Gaps!
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 Wh
r? ere
nte pla
e ce
hen my
sto
W p?

Execution

What is my profit target?

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Entry Timing

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 Why I Enter At The Open
Simplifies execution
Minimizes emotion
Takes advantage of rookie psychology (i.e.
those chasing the market)
Easier to back-test
Focuses the effort on the system (not me)
Catches the 30% that begin filling at, or soon
after, the open*
(*note: assumes opening gap size > 20% of 5 day ATR, with 10% of 5 day ATR stop, ES, 1998-2007)

Copyright 2010, Master The Gap, Inc.

Target Selection

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 To Scale Out or Not?

Target % of Gap Fill % Win Rate Avg Winning Trade

25% 90.9 $570
50% 84.8 $1,076
75% 78.7 $1,537
100% 74.6 $1,836
125% 70.3 $2,184

Note: Fade medium & large opening gaps (> 20% of 5 day ATR) of the E-mini S&P 500 futures, regular trading hours, target = gap fill
(prior daily close), no stop, exit at end of day. Results include 1,342 trades from 1998-2008.

75%
75%chance
chanceof
of$1,836
$1,836-or-
-or-85%
85%chance
chanceof
of$1,076
$1,076
Which
Whichwould
wouldyou
youprefer?
prefer?
Copyright 2010, Master The Gap, Inc.
What Else Does This Slide Tell Us?

Target % of Gap Fill % Win Rate Avg Winning Trade

25% 90.9 $570
50% 84.8 $1,076
75% 78.7 $1,537
100% 74.6 $1,836
125% 70.3 $2,184

Note: Fade medium & large opening gaps (> 20% of 5 day ATR) of the E-mini S&P 500 futures, regular trading hours, target = gap fill
(prior daily close), no stop, exit at end of day. Results include 1,342 trades from 1998-2008.

ItItPays
Paysto
toStay!
Stay!
Price
Priceoften
oftenextends
extendsbeyond
beyond(i.e.
(i.e.through)
through)the
thegap
gapfill.
fill.
Copyright 2010, Master The Gap, Inc.
Stop Placement

Copyright 2010, Master The Gap, Inc.

 Stops
25% 40% of a five day ATR (avg. true range) works well
for most indices depending upon the volatility of the
security
5 8 points in the E-mini S&P 500 has worked well
historically (~ $.50 $.80 in the SPY)
If I increase stop size to accommodate volatility, then I
always reduce position size to ensure my max loss per
trade is not exceeded
I never hold trades overnight

Stop
Stopsize
sizeis
ismore
moreofofaapersonal
personal
preference
preferencethan
thanprofitability
profitabilitydeterminant
determinant
Copyright 2010, Master The Gap, Inc.
 Summary
Historical probabilities level the playing field
between the Pros and the Joes

Trade selection is the key

Larger stops have many benefits

It often pays to stay (hold beyond initial target)

Thank
ThankYou
You
Copyright 2010, Master The Gap, Inc.
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