Profitable ETF Trading Strategies: how to trade the opening gap
There are literally hundreds of tactical trading books in the marketplace these days. Almost every one of them will discuss the authors favored strategy or strategies for trading the opening gap. The strategies are typically framed as a set of trading heuristic rules, of more or less complexity, and they’re backed up with assertions of excellent performance. When you set all the strategies side by side you realize that many of them are diametrically opposed to a different author’s favored strategy.
How can all of these authors be right about trading a period of time measured in minutes, where volatility is at its highest, and where false starts, false breakouts, gap closures, and reversion to the mean are so commonplace and confusing to the new trader?
Is the opening gap simply something that new trader should avoid until they have years of experience in hand? Or should a new trader just pick a strategy from a favorite author and try to make it work with small position size and move along until you find something that works? How long should you wait before the morning gap is over and you can start trading intraday on a more reliable basis?
These are not trivial questions. Intraday traders must struggle with these questions until they find the solution that is satisfactory to them.
My own research into gaps discovered some surprising truths. What I found was that the many different authors were occasionally right and occasionally wrong. I found that the truth about the gap and the best way to trade it varied in time on a regular basis.
I studied years worth of opening gaps of the market and found that there are times when the market reliably moves in the same direction as the opening gap, and times when the opening gap is reliably reversed, and many times when the market seems to be random with respect to the follow-through after the gap.
The one reliable correlation that I found was that the magnitude of the gap in either direction correlates to the magnitude of the follow-through in either direction. Simply stated, large gaps make for large follow-through’s. But, unfortunately, there is no predictive value on the direction of the gap and the subsequent move on a regular basis.
I also found that the truth of the market’s behavior at the gap changes in time periods measured in days and weeks. The truth is not persistent. Study of the gaps may point out moments when you can justify a directional bias but most of the time the correlation is so weak or nonexistent that there is no statistical edge.
What does this all mean?
I conclude that you should be very careful about it except in wisdom from even the most popular tactical trading authors and conduct your own research with respect to the gap in a way that makes sense for the type of trading that you propose to do. There is very little about the gap that may be safely and universally generalized for the average trader.
I have a set of trading strategies that work for me and my style that took months to refine and only applying under strict conditions with limited opportunities. When those moments occur I am ready to trade according to my edge, but I also know how narrow the windows of opportunity really are.
If you must trade the gap, then be very careful.