an opening gap, which is the first condition for entering a gaptrade.
1. Opening gap higher (gap up). This occurs when the opening pricefor the day is higher than the high of the previous day. SeeFigure 12-1 for an ideal representation of the gap higher open.See Figure 12-2 for examples of gap higher openings. Note thatwhen I refer to the “opening,” I mean the first “print” price orthe officially defined opening as determined by the givenexchange.
2. Opening gap lower (gap down). This occurs when the openingprice for the day is lower than the low of the previous day. SeeFigures 12-3 and 12-4. Again, by the “opening” I mean the firstGap Methods for Day Trading 137
Today’s Open ———— =
Size of GapHighYesterday ———-LowFigure 12-1. Ideal representation of a gap
higher opening.
 
Figure 12-2. A daily chart of Swiss franc futures showing only gap higher openings.138 = Chapter Twelve
High
Yesterday ——>—-
Low Size of Gap
Today’sOpen
Figure 12-3. Ideal representation of a gaplower opening.
1712/98
see : “pRrows Pay GAP LOWER santC= 6852: oJ 5
 
Figure 12-4. A daily chart of Swiss franc futures showing only gap lower openings.Gap Methods for Day Trading 139
“print” price or the officially defined opening as determined bythe given exchange.
The opening gap up sets the precondition for a short sale. Theopening gap down sets the precondition for a buy. Note that agap up opening does not immediately give a sell short signal. Itmerely sets the first condition for a sell signal. A gap downopening does not immediately signal a buy. It merely sets thefirst condition for a buy signal.
How a Basic Gap Buy SignalIs Established
A basic gap buy signal occurs when a market opens on a gap downand then comes back up to penetrate the previous day’s low by agiven number of price ticks. When this occurs you buy for a daytrade. You exit your trade either at a fixed-dollar-amount stop loss,a stop loss below the low of the day when you are filled, or MOC(market on close).
How a Basic Gap Sell SignalIs Established
A basic gap sell signal occurs when a market opens on a gap upand then comes back down to penetrate the previous day’s highby a given number of price ticks. When this occurs, you sell shortfor a day trade. You exit your trade either at a fixed-dollar-amountstop loss, a stop loss above the high of the day when you arefilled, or MOC (market on close).
As you can see, the rules of application for the gap trade arevery simple. And the application of this methodology is simple aswell. Figures 12-5 and 12-6 show ideal buy and sell signals.Figures 12-7 and 12-8 show actual buy and sell signals.
It should be noted that in trading gaps use only the day sessionprices. I repeat: In determining whether a gap has been made ornot, do not use the overnight or Globex data. Gaps are determinedbased on day session data only! This is very important.Chapter Twelve
High
saeemeeessesernes Buy on
Low a penetration
f this low bToday’ —_ ° yy's Open a given amount(penetration size)Figure 12-5. Ideal gap buy signal.Today’s Open ———j=— ==Hian eseeeeeseseseee Sell short ona penetrationof this high bya given amountYesterday ——>—- (penetration size)Low
Figure 12-6. Ideal gap sell signal.
Psychology of the Gap Trade
In the psychology of the gap trade is found the reason for itsexcellent ability to capture winning day trades. When a marketopens on a down gap, traders often panic and sell out. If the mar-ket can absorb their selling and then move up high enough topenetrate the previous day’s low, the sellers realize that they'vemade a mistake (oops, we’ve made a mistake) and enter theiron 193209 x SAWS PewemmATion PonsT. :i 1383 Aegout chow Garsell Sigua *Figure 12-8. Actual gap sell signals. Arrows show gap sell signals; “X” shows penetration point.
 142 ~~ Chapter Twelve
longs again. At the same time, buyers waiting for a sign that theopening down gap was a bogus sign of weakness enter the mar-ket and bid prices higher. The market then usually closes near itshigh for the day.
The psychology of the sell gap is similar, only in reverse. Sellersexit en masse to cover shorts and to buy into new longs on a gaphigher opening, thinking that the gap up is a sign of strength.When it fails to materialize, they exit and push prices downsharply. The psychology of the gap trade is, therefore, one of panicselling and panic buying. Gaps are highly correlated with topsand bottoms to the extent that gap trades occur frequently at ornear market bottoms, whereas sell gap trades occur at or nearmarket tops.
The “Best” Gap Trades
You might think that the best gap trades (by which I mean mostprofitable and most reliable) occur consistent with the extant trend.This is not necessarily true. Some of the best buy gap trades occur inbear markets as short covering panics occur. Some of the best sellgap trades occur in bull markets as traders take profits en masse.
Gap trades have had a noteworthy history. They are reliable andoften profitable because they're based on the essential principlethat underpins all trading psychology. As long as traders trademarkets and as long as traders are human, gap trades will contin-ue to work. And if they stop working, then I’m certain other psy-chologically based trading patterns will take their place.
Here is a review of the basic gap trade rules:
= To trade gaps the market must open either above the previousdaily high or below the previous daily low by a given numberof ticks or points.
— a A gap buy signal is generated once the market has opened on agap lower and then comes back up to penetrate the previousdaily low by a given number of ticks.
= A gap sell signal is generated once the market has opened on agap higher and then comes back down to penetrate the previousdaily high by a given number of ticks.
= Gap buy or sell trades are closed out at the end of the day or at apredetermined stop loss.Gap Methods for Day Trading 143
Pragmatic Considerationsin Trading Gaps
While theory is one thing, reality is another. The reality of gaptrading is that it is not appropriate in all markets and it is notappropriate at all times. The fact is that the two most importantday-trading criteria must be met if the gap is to be used effective-ly: volume and volatility. Gap trades based on my rules can workwell in markets such as S&P 500 futures, but they are doomed tofailure in a market like oats, where trading volume is thin andwhere volatility is minimal (most of the time).
Another practical consideration is the use of stop losses. As youwell know, there are three schools of thought on stop losses:
1. The best stop loss to use in a market is a risk management stop.In other words, risk a certain amount of money on each trade,and if the stop is hit, then exit.
2.A stop loss should be determined on the basis of your systemand not on the basis of dollar risk.
3. A trailing stop loss should be used once a given profit target hasbeen hit in order to preserve the profit.
These, then, are the basic stop loss strategies. Naturally, there arevariations on the theme; however, my research has clearly indicat-ed the following best strategies for gap trades as well as for mostday trades.
= A dollar risk management stop loss is best as an initial stop.
= Once a given profit level has been achieved, a trailing stop lossis effective.
= The trailing stop loss must be a large one. In other words, youmust be willing to risk up to 90 percent of your open profit, oryou will be stopped out repeatedly.
= Small stop losses will work against you in gap trades, and infact, a small stop loss will work against you in virtually all typesof trading other than “scalping.”
In some cases, holding a gap trade overnight may prove moreprofitable than exiting at the end of the trading session. But notethat the trade would then no longer be considered a day trade.This method will be discussed later in this chapter.144 = Chapter Twelve
Variations on the Gap
Trade Theme
While the gap trade method is a viable method for day trading inactive and volatile markets, I have discovered and researched sever-al variations on the gap trade methodology that can make a signifi-cant difference in the bottom-line results. They are discussed below.
Gap Size. The size of the opening gap is important. LarryWilliams, my colleague, friend of many years, and originator of thegap trade method, has often quipped “the bigger the gap, the bet-ter the trade,” and I certainly agree with him. Shown in Figure 12-9is a comparison of gap size and average profit per trade for gaptrades in S&P futures covering the period from April 1982 (theinception of futures trading) through January 1998. I’m certainyou'll agree that this is a sufficiently lengthy test period in terms ofstatistical validation.
The gap size figures suggest, but do not conclusively confirm,that a larger gap size is preferable. They do, however, show thatthere is a tendency for higher opening gap sizes to produce a larg-er average profit per trade than smaller gap sizes. A more effectiveapproach is to use a different-size opening gap for buy signals andfor sell signals. Since markets are not linear, this makes a greatdeal of sense. By varying the parameters, you will be able to fine-tune the gap trade method for a variety of markets.
Gap Penetration Size. This variable is also important. It mea-sures how much the market penetrates back into its previous dailyrange for buy and sell signals. In other words, a smaller penetra-
 
 
Gap size (ticks) Average trade ($)2 1733 1255 5010 31615 29635 377
 
Figure 12-9. Average profit per trade as a function ofopeping gap size in S&P gap trades 1982-1998. Longs andshorts.Gap size
251015
Gap Methods for Day Trading 145
 
Average trade ($) Percentage accuracy120 56189 58393, 60425 61
Figure 12-10. Average profit per trade as a function of penetra-tion size in S&P gap trades 1982-1998. Longs and shorts.
Stop loss ($)
10001300200025005000
Average trade ($) Percentage accuracy512 58586 60550 60506 60556 . 62
 
Figure 12-11. Average profit per trade as a function of stop losssize in S&P gap trades 1982-1998. Longs and shorts.
tion size will give more trades. However, is it possible that a largerpenetration size will give fewer trades but with higher accuracy?Figure 12-10 gives us an idea of how penetration size is related toaverage profit per trade.
The optimum numbers for gap penetration size were 10 ticks forlongs and 12 ticks for shorts. The results using these entry gapsizes were 62 percent and $455 average trade for the period from1982 through 1998 in S&P futures.
Stop Loss Size. Stop loss size is also very important. Shown inFigure 12-11 is a tabular listing of stop loss size with average profitper trade in S&P futures. As you can see, a larger stop loss ispreferable for higher accuracy.
Period of Gap Comparison—Multiple-Day Gap Signals
I am about to make a major change in the gap concept as present-ed heretofore, so hold on to your hat, since you'll need to haveyour thinking cap on for this one. While we know that the gap146 = Chapter Twelve
trade as I’ve discussed it so far is a good method for day trading,there is a variation on the theme of the gap trade that you maywish to consider. Consider the fact that a gap can be referencedback to the previous day or to any number of days back.
The Multiple-Day Gap
Signal (Multigap)The traditional or basic buy/sell gap signal has already been dis-cussed in this chapter. The gap approach has merit; however, thereis a variation on the theme of the gap trade method that mayprove even more valuable. While the basic gap method isdesigned for day trading, there is a way to capitalize on the gapidea for short-term trades. The multigap is also useful for daytrading, particularly in S&P futures where the accuracy and aver-age trade increase. (I will show these statistics later after I explainthe multigap method in detail.)
As you know, the basic gap signal occurs when a market opensbelow the low of its previous day and then penetrates the low onthe way back up (buy signal) or when a market opens above thehigh of its previous day and then penetrates the high on the wayback down. Entry is made on a buy or sell stop and exit is on theclose of trading. In active markets such as S&P futures, this method-ology has merit and back-tests profitably over many years of histor-ical data. My recent test of the gap day trading method in S&Pfutures back to 1982 shows the system as having been correct 60percent of the time with an average profit per trade of $497. This isvery respectable for a day-trading method. There are ways to boostthis figure to over 80 percent with nearly twice the average trade.
The Multigap Explained
The multigap is a simple method. Rather than generate a signalbased on an opening gap above or below the previous day’s highor low, the signal is generated based on an opening gap above orbelow the highest high or the lowest low of the last x number ofdays. The x is determined for each market based on the volatilitycharacteristics of the market. What will work for S&P because ofits volatility will not necessarily work for oats. Ideal examples ofthe multigap buy and sell signals are shown, respectively, inFigures 12-12 and 12-13.Gap Methods for Day Trading 147
Buy onpenetrationof this lowLast “X” Se L L by “X” ticks
a Today’sopen isbelow lowest
low of previous “X” days(in this case 8 days)
Figure 12-12. Multigap buy signal.
Today's open is
above highest
high of previous
“xX” days
- ~~ this case 8 days)
Last “x” me aeeeneenee
Ne short onpenetration+ L of this high
by “X” ticksFigure 12-13. Multigap sell signal.
Rules of the Multigap Method
Following are some rules to keep in mind when using the multi-gap method:
= If a market opens below its lowest low of the last x days, thenbuy on a penetration back up through the low by x ticks.148 = Chapter Twelve
« If a market opens above its highest high of the last x days, thensell short on a penetration back down through the high by xticks.
« Exit on a predetermined risk management stop loss, on the closeof the day, or on the nth profitable opening
Note that by x days I mean a given number of days as defined forthe indicated market. The x days can be different for buy signalsand for sell signals. The nth profitable opening is also determinedby market. By a profitable opening I mean an opening price that isabove the buy price or below the sell short price. You simply countthe number of days in which the opening was profitable. Then onthe nth profitable opening, you exit (unless you have beenstopped out first). See Figures 12-14 and 12-15.
This is a truly simple approach that I believe has considerablemerit for position traders. You might want to take some time toevaluate this method. (See Figures 12-16 through 12-18 for addi-tional historical test results.)
As mentioned, based on my initial historical testing in S&Pfutures from 1982 through 1998, I show an accuracy of 60 percentwith an average trade of $482 (slippage and commission deduct-ed). The entry parameters are 9 days for buy signals and 2 daysfor sell signals. In order to find the best fit, you will need to adjustgap size and penetration size. Hence, the regtilts could be evenbetter than what is stated above. As you can see, this is animprovement on the basic gap method previously described. SeeFigures 12-16 and 12-17.
Holding beyond the Day Time Frame(Exit on Nth Profitable Opening)
Sometimes it pays to hold slightly beyond the time frame of oneday. Using the multigap method in S&P and exiting on the firstprofitable opening, my initial historical testing in S&P futuresfrom 1982 through 1998 shows an accuracy of 85 percent with anaverage trade of $780 (slippage and commissions deducted) basedon a window of 9 days for buy signals, 2 days for sell signals, anda few more parameters for stop-loss and amount of gap penetra-tion. See Figure 12-18.
In some markets, gap trades that show a poor record of successwhen closed out at the end of the day can improve dramaticallyGap Methods for Day Trading 149
(SP 55/99) S&P 500 INDEX 55/99 . 01/02/98
 
 
 
 
 
Figure 12-14. Multiple-day gap trades in S&P 500.150 = Chapter Twelve
jb.Gap System S&P 500 INDEX 55/99-Daily
Total net profitGross profit
Total # of tradesNumber winning trades
Largest winning tradeAverage winning tradeRatio avg win/avg loss
Max consec. winnersAvg # bars in winners
Max intraday drawdownProfit factorAccount size required
Total net profitGross profit
Total # of tradesNumber winning trades
Largest winning tradeAverage winning tradeRatio avg win/avg loss
Max consec. winnersAvg # bars in winners
Max intraday drawdownProfit factorAccount size required
Total net profitGross profit
Total # of tradesNumber winning trades
Largest winning tradeAverage winning tradeRatio avg win/avg loss
Max consec. winnersAvg # bars in winners
Max intraday drawdownProfit factorAccount size required
Performance$ 85350.00$ 155700.00
177
107$ 25125.00$ 1455.141.45
9
0$ -10700.002.21$ 10700.00Performance$ 48025.00$ 71050.00
50
34$ 25125.00$ 2089.711.45
8
0$ -9925.003.09$ 9925.00Performance$ 37325.00$ 84650.00
127
73$ 6850.00$ 1159.591.32
8
0$ -9825.001.79$ 9825.00
Summary: All TradesOpen position P/LGross loss
Percent profitableNumber losing trades
Largest losing tradeAverage losing tradeAvg trade(win & loss)
Max consec. losersAvg # bars in losers
Max # contracts heldReturn on account
Summary: Long TradesOpen position P/LGross loss
Percent profitableNumber losing trades
Largest losing tradeAverage losing tradeAvg trade(win & loss}
Max consec. losersAvg # bars in losers
Max # contracts heldReturn on account
Open position P/LGross loss
Percent profitableNumber losing trades
Largest losing tradeAverage losing tradeAvg trade(win & loss)
Max consec. losersAvg # bars in losers
Max # contracts heldReturn on account
04/21/82 - 01/02/98
Poeun ay
Lar
MO
in
eae
0.00-70350.00
60%70
-4575 .00-1005.00482.20
0.00~23025.00
68%16
-4575.00-1439.06960.50
0.00-47325.00
57%54
-4575.00-876.39293.90
50
380%
Figure 12-15. Historical record of multiple-day gap trade S&P 500 1982-1998.. eof Hinge
yttyt. .
tel te oet figaee
 
Figure 12-17. Multigap sell signal and exit in pork belly futures.
ii{}ii£1ieii'Lt}|i§it152 = Chapter Twelve
jb.Gap System S&P 500 INDEX 55/99-Daily
04/21/82 - 01/02/98
 
 
Performance Summary: All TradesTotal net profit $ 131875.00 Open position P/L $ 0.00Gross profit $ 220250.00 Gross loss $ -88375.00Total # of trades 169 Percent profitable 85%Number winning trades 143 Number losing trades 26Largest winning trade $ 26875.00 Largest losing trade $ -5600.00Average winning trade $ 1540.21 Average losing trade § -3399.04Ratio avg win/avg loss 0.45 Avg trade(win & loss) $ 780.33Max consec. winners 18 Max consec. losers 2Avg # bars in winners 2 Avg # bars in losers 3Max intraday drawdown $ -12850.00 .Profit factor 2.49 Max # contracts held 1Account size required $ 12850.00 Return on account 1026%
Performance Summary: Long TradesTotal net profit $ 66175.00 Open position P/L $ 0.00Gross profit $ 89100.00 Gross loss $ -22925.00Total # of trades 49 Percent profitable 86%Number winning trades 42 Number losing trades 7Largest winning trade $ 26875.00 Largest losing trade $ ~-4575.00Average winning trade $ 2121.43 Average losing trade $ -3275.00Ratio avg win/avg loss 0.65 Avg trade(win & loss} $ 1350.51Max consec. winners 14 Max consec. losers 2Avg # bars in winners 1 Avg # bars in losers 1Max intraday drawdown $ -8050.00Profit factor 3.89 Max # contracts held 1Account size required $ 8050.00 Return on account 822%
Performance Summary: Short TradesTotal net profit $ 65700.00 Open position P/L $ 0.00Gross profit $ 131150.00 Gross loss $ -65450.00Total # of trades 120 Percent profitable 84%Number winning trades 101 Number losing trades 19Largest winning trade $ 9050.00 Largest losing trade $ -5600.00Average winning trade $ 1298.51 Average losing trade $ -3444.74Ratio avg win/avg loss 0.38 Avg trade(win & loss) $s. 547.50Max consec. winners 19 Max consec. losers 2Avg # bars in winners 2 Avg # bars in losers 4Max intraday drawdown $ -13575.00Profit factor 2.00 Max # contracts held 1Account size required $ 13575.00 Return on account 484%
Figure 12-18. Multiple-day S&P 500 gap trades with exit on first profitable opening
using parameters.Gap Methods for Day Trading 153
using the multigap method. In T-bond futures, for example, thesimple gap method back-test in T-bonds shows a 50 percent accu-racy with an average trade of only $56. But holding the trade withan exit on the first profitable opening yields an 85 percent with anaverage trade of over $224 for the period from 1978 to 1998.
As another example, the basic gap trade in coffee futures pro-duces an average trade of $137 with 54 percent accuracy if exitedon the close. However, using the multigap method, accuracyincreases to 67 percent with an average trade of $424 over the peri-od from August 1973 through January 1998.
Take a little time to review this approach in a number of differ-ent markets. You may find it worth your while to pursue it.
Intraday Follow-Up of
Gap Trades
Summary
Finally, another aspect of the gap trade is the trailing stop loss. Forthose who are active day traders, a trailing stop loss method maybe a valuable addition to the gap trade and/or the multigap trade.Use the guidelines presented previously in this book to implementa trailing stop loss.
The basic gap trade as I have previously presented it in TheCompleat Day Trader and in this chapter is a basically soundmethod. It performs best in S&P futures. A variation on the basicgap method is the multigap method. The motivated trader willtake a little time and effort to find the best combination of themajor variables associated with both the gap trade and the multi-gap trade. These variables are length of days in gap window, thesize of the gap, the size of the gap penetration, and the stop loss.Another effective method would be to use a trailing stop loss oncea gap trade or multigap trade has been entered. While the trailingstop loss may decrease accuracy slightly in some cases, there aremarkets in which accuracy increases, as well as average profit pertrade.Accumulation DistributionOscillator Derivative
Fortid fortuna adiuvat.Fortune favors the brave. TERENCE
For many years traders have attempted to find a method that willgive insight as to the locus of control in a market. By this I meanthe balance of power. The question as to whether the bulls or thebears are “in control” of a market is an important one, particularlyfor the day trader. If we know that the bulls are in control of amarket, then we will do well to buy on declines, knowing that themarket is likely to recover quickly from its drop. In a market thatis controlled by the bears, rallies will be relatively short-lived, assellers overpower buyers and the market returns to its decliningtrend.
By “control” I do not mean to imply that there is an actualgroup of buyers or sellers who are conspiring to control the direc-tion ofa market. Rather, I mean essentially “balance of power.” Ineffect, the amount of buying power exceeds the amount of sellingpower or vice versa. Certainly, the balance of power will shift atsome point, usually after the buying power and the selling pres-sure have reached a point of equilibrium and the tide changesdirection. Although the trend can change rapidly in someinstances, there are usually warning signs that precede changes intrend.156 = Chapter Thirteen
SELLING PRESSURETRIBUTION
    
ACCUMULATION
  
BUYING POWER
ACCUMULATIONFigure 13-1. Ideal representation of buying power versus selling pressure.
At times the indications are subtle, and at times they are obvi-ous. But this is not always the case. And this is what makes trad-ing systems imperfect. There is no certain way I know to detectwhen the balance of power will shift. The ideal situation of buyingpower versus selling pressure can be depicted graphically asshown in Figure 13-1.
The Ideal Situation
In a perfect world we would like to see markets follow our para-digm as closely as possible. While this would make our task astraders more definitive, it would likely mean an end to free mar-kets, since virtually every market trend and trend change wouldbe predictable and there would, therefore, be no need to trade.Figure 13-1 illustrates the phases of a “normal” market as itmoves from a neutral phase to a bullish phase and then to top-ping, bearish, and bottoming phases.
The accompanying 10-minute Swiss franc futures chart(Figure 13-2) shows how a market enters a topping time frameand then turns lower. Theoretically, as the market moves side-ways, a change of control is taking place as the bears gain theupper hand. One interpretation of what is actually happening isthat selling pressure outweighs buying power. During this side-ways phase the bears are “distributing” contracts to the bulls.The bulls eventually reach a point where their cumulative buy-ing can no longer sustain an uptrend, and the market drops asthe bears continue their cumulative selling. 
Accumulation Distribution Oscillator Derivative 157
Asus 10 MINUTE BAR 97 COG INE
a iBUTION
Figure 13-2. 10-minute Swiss franc futures showing a topping or distribution phase prior to
a decline.
At a market bottom the reverse holds true. In theory, the buyingpower outweighs the selling pressure. There is cumulatively morebuying than there is selling. Eventually the balance is overcome asbuying demand outpaces the supply of selling, and the marketsurges higher as the bulls gain firm control of the market. Figure 13-3shows an accumulation pattern in the 10-minute S&P 500 futureschart. Note that the market enters a period of sideways movementprior to a sharp rally. Theoretically, the bulls are slowly but surelygaining control of the market during the bottoming or “accumula-tion” phase.
Note that the situation I have described herein is an ideal situa-tion. Markets do not always follow their ideal situations. At times amarket will change trend almost immediately and seemingly with-out notice. Purists will argue that in such cases markets do giveadvance warnings but that the signs are subtle. I do not disagree.However, I note that if the signs cannot be found, then the theory,no matter how cogent and valid, will not help us.158 = Chapter Thirteen
Pik iF BXHS 10 MINUTE E BAR —_—____@ |e? (96 J
Be
Wy
sees ns ABUMURTIR, ,ox bila : :
He 23240
C= 95860
 
Figure 13-3. 10-minute S&P 500