By Mircea Dologa, MD, CTA*
Posted: June 13, 2008
The mysteries of trading the opening gap have eluded most traders. Only astute traders have had the courage to conceive of and execute these trades. One could wonder why. Well, the complexity of market flow achieves all of its importance well ahead of the "ringing bell" signal. Even if the mysterious air of the opening gap dissipates rapidly, as soon as he / she comprehends its foundation, the trader still has to work on everyday trading techniques.
Some traders will say that "the first hour is the novice's" and the last one "belongs to the professional trader"! Well…I completely disagree with this! Opening trades have a high level of complexity, and their comprehension takes time, at least several years of experience.
We should not neglect the role of fundamentals and a keen sense of contextual and local market flow geometry. Money and risk management ensure the safety of the overall trade.
We will try to elucidate the procedural steps necessary to trading the opening market. The trader should be warned that this study is not exhaustive.
The Concept of the Opening Gap
The opening price carries a great deal of weight. It gives the trader the chance to analyze and actualize market activity during the "teens of hours" overnight silent period. For an intra-day trader, the closing price is not as important as the opening price. The latter makes all the difference in preparing an intra-day trade, as soon as the dynamics of the opening market allow it.
The occurrence of the opening gap is due to external and / or internal factors, thus influencing, not only the immediate post-opening market behaviour, but also the entire day's market movements.
A definition of the opening gap obviously comes from visual observation of the market interruption in regard to yesterday's close. It is vital that it be correctly defined because the gap's height boundaries are used to measure the location of the logical objective targets, thus heavily contributing to the outcome of the entire trade profit.
Richard W. Schabacker, one of the technical analysis giants, has written in his 1932 book titled, Technical Analysis and Stock Market Profits, the following:
"A gap is a stretch of "open water" between the price ranges of two successive trading days as pictorialized on our stock charts."
On the charts, the reality of market flow interruption constrains us to accept the definition of the gap as the price distance located between the close of the last bar (yesterday's last bar) and the open of the next period bar (today's opening bar). However, we can always consider a second definition when the gap's height is taken as the difference between the gap's high and low levels.
In our opinion, the former definition doesn't invalidate the latter. As we know, trading is a collection of techniques. The consistent trader has the ability to use the right tool at the right time. Thus, he or she will consider the gap's definition that best suits his / her most adequate trading tool, and, in return, the chosen tool will optimally describe the local market well carved in the market context.
The Influence of External Factors
As we have already mentioned, the inception of the opening gap can be caused by external factors:
Outside the traded market fundamentals: The rise of the interest rate or of crude oil, a drop of the U.S. dollar or a sudden rise of the Nikkei 225 due to its in-land positive economical news. Inter-market analysis, related factors and the news would induce a strong but short-lived momentum. The local market, including the gap, will be heavily influenced but not the contextual market.
Inside the traded market fundamentals: The up / down sloping of the mosaic composed of stocks of the index. As an example, we took the German Dax 30.
Figure 1. The Excel file shown previously assists the trader in evaluating the weight of an index's Tier 1 stocks, which will greatly influence the behavior of the entire 30-stock index. Their positive or negative intra-day changes will efficiently reveal, not only the day's opening, but will also control the intra-day market activity.
A detailed analysis of the index composition (refer to Figure 1) will reveal:
The weight of each stock within the index varied from 0.46% to 10.52% as of February 21, 2008.
The weight percentage addition of the first 6 to 12 stocks that comprise the index gives 47.99% to 75.96%, as follows:
The first 6 ascending percentage sorted stocks form a total of 47.99% of the index.
The first 8 ascending percentage sorted stocks form a total of 59.37 of the index.
The first 10 ascending percentage sorted stocks form a total of 68.91% of the index.
The first 12 ascending percentage sorted stocks form a total of 75.96% of the index.
By plotting in green, the number of up-trending stocks, and in red, the down-trending stocks, we can closely follow, in real time, the predominant color, so as to observe the trend. Even more, by considering at least 25 one-color (green or red) plotted stocks, we can be assured of a very high probability of the continuation of the ongoing (up or down) trend.
We can also study, in even more detail, the corresponding percentage of the first 12 heavy-weight stocks, representing 75.96% of the index, within the one-color trending group and dramatically reduce the number of leading stocks, from 25 to 12 or even less.
In spite of their significant role, the impact of the external factors will progressively wane, and their effects will not really last the whole morning. Then, the chart-related internal factors would take over, continuing the ongoing trend as if nothing had happened.
Now, if you carefully study the contextual market, you will notice that the charting portion of the gap event and its related influences look like an intruding graft. If by any chance, the post-gap chart picture is amputated from the graft period, the trend of the separated charts put together will almost perfectly fit…the market never leaves any loose ends!
The Influence of the Chart-Related Internal Factors
As we have mentioned before, the consistent trader has the choice of using the optimal technique at the right time. The trader must ingrain this principle in his / her mind via repetition. As traders, we are what our daily routines are…no more, no less! So, let's study the different elements that will eventually be part of the trader's tactics when trading the opening market.
The Gap's Size Will Guide Our Trading Decisions
The location and size of the gap within the context of the market is very often a neglected factor. Many traders, especially novices, trade a zoomed market on a 5- or 15-minute time frame. They do not take advantage of the previous day's chart activity, with the pre-closing events that may or may not continue into the next day's morning.
Small gaps (less than 10 Dax points) witness the continuation of the prior day's trend. Medium gaps (less than 25 Dax points) will probably signal a breakout gap, the first element of the trend's inception. The "raison d'être" of this type of gap is market acceleration. Even if there is strong news, the high-powered momentum is not fully discounted yet, and the trend could continue in the direction of the news.
Large gaps (more than 50 Dax points) indicate an elongation of the current market. Thus, the market has already discounted the event. The rubber-band effect will occur promptly, and the market price will reverse to the mean. A strong correction and a re-assertion of the pre-gap period seem to be implemented rapidly. However, the return to normal will usually take from a few hours to several days. This forms a great counter-gap trading opportunity. It could really be the day that makes your monthly profits!
The Gap's Location within the Trend Definitively Defines the Gap Type
A multiple gap-triggering mechanism could occur within the developing trend, especially in the beginning. The trader should expect a breakaway gap -- the starting blocks of the commencing trend, a continuation gap (an acceleration at the midpoint of minor wave 3 of the primary Wave 3 -- w3:W3 -- which ensures momentum's inertia), an exhaustion gap (current trend termination and possible reversal signal) and even a reversal island pattern (a double gap pattern).
Figure 2. The chart shown previously illustrates the distribution of multiple, varied gaps within the primary Elliott Wave 3 development.
There are two most representative gaps: The breakaway gap n° 1 -- doubled here, which ignites the development of Elliot Wave 3 and the continuation gap n° 4, which enhances the notion that it usually reveals the midpoint of the Elliott Wave 3. It is important to observe that all these gaps occur at Fibonacci levels (refer to Figure 2).
The astute trader knows that every market opening should be scrutinized through the filter of the upper time frame in the quest for the gap's contribution to the current trend. It's the only way to be aware of the type of gap and of the proper trading technique to be applied.
The breakaway gap is born out of a consolidation pattern, and it is almost never filled. Most of the time, it triggers the mechanism of multiple gaps. The signs of a breakaway-type gap include the following.
The presence of a trading range, which has a great breakout potential, is revealed by its classic volume value being greater than its specific moving average.
The magnitude of high-powered momentum is often illustrated by the occurrence of huge bars. A great tip is to expect a volume increase, at or just after the breaking bar. The volume timing can be concomitant, during or just after this incipient bar.
The continuation or runaway gap is usually located at the midpoint of the current trend, and it mostly never fills. The tip here concerns the volume: It is of a lesser degree than that of the breakaway gap, and it might even decrease in case of a down trend.
The exhaustion gap occurs at the terminal portion of a trend and will be filled shortly after its birth. The volume is lesser than that of the last two gaps but still substantial. The tip here is to wait for another gap, just after the reversal; thus, the island reversal pattern is born. The latter is the only chart pattern having two gaps: First an exhaustion and, then, on the counter-trend, a breakaway gap.
As we have seen in the previous description, the opening gap is more complex than it seems to be. The trader must not only closely follow the development of the trend on the contextual market flow (usually the upper time frame), but he / she will have to evaluate the type of gap, the inherent volume and, of course, the projected target, so money management procedures can be easily implemented.
Opening Range, Channel Range and the Extension of the Opening Bar
We are always in the quest to apply Fibonacci ratios, not only to common swings, but also to the trading ranges that are far less known by the crowd. To delineate the opening range, we wait for approximately 20 to 30 minutes.
The channel range is nothing else but a slant trading range, which may occur in pre-open or after-noon of yesterday's market, or on the contrary, during the first 30 to 90 minutes of the opening.
The opening bar is the first bar of the opening market and must have a consistent height, usually at least 1.5 times the Average True Range (ATR-13). When trading the opening market, the trader uses a 5-minute chart or (less frequently) a 10-minute chart. In this way, the 5-minute chart will show the correct number of trading range bars (4 to 12 bars), which could be significant for the implementation of Fibonacci ratios applied to the height of the opening range, the channel range or to the height of the opening bar.
You would be surprised how many times the extensions of the three elements will intersect, forming a cluster and / or a confluence, an excellent halting chart formation, not known by many traders. Always expect the number of extensions to be close to 7 or 13 Fibonacci numbers or a Lucas number, such as 11 (refer to Figure 3).
Figure 3. The role of the extensions is illustrated here in all its splendor. The Opening Range (OR) and the Channel Range (CR) realize a "mystical intersection" -- called confluence -- the place where the last CR slants meet the last OR horizontal trend lines…or shall we say…the place where time meets price?
The trader should observe an eventual preceding consolidation within the pre-close or within the opening range period (refer to Opening Range Zero Ground -- OR 0 -- illustrated in the lower portion of Figure 3), which will be defined as the nest of the trend. Its extensions could mark the halt of the morning's activity in the OR11 / CR11 confluence zone, in a flip of a dime (refer again to Figure 3). The price will drift back in the direction from which it came.
Trending Tools
Once the market opens and the trend is established, the developing movements are in process. We should prepare for determining the trend's termination levels in such a way that the trading potential remains optimal. The tools are multiple, and the consistent trader will know the best choice at the right time, in spite of the tools' multi-level complexity (refer to Figure 4).
Figure 4. Checklist: Synopsis of the multi-level complexity tools used to trade the opening
General Tool Guide for Trending -- Impact on Market Opening
Please refer to Figure 4 for a checklist that is a synopsis of the opening gap tools. Just keep in mind that these tools are for evaluating the strength of the trend, thus offering a low-risk, high-probability opening gap-related trade.
Dr. Andrews' pitchfork technique will help us closely follow up the market direction. There is a high probability that it will reveal the targets, the stop losses and also the reversal levels. Its nuts-and-bolts are prolific: Single and multiple channeling, the magnet power of the median line with its velleities and also the confluence zones with their energy building clusters. Thus, the classic components of an entry are efficiently revealed: Piercing, test and re-test, zooming and the too-often-neglected price failure.
The Bollinger Bands signal the degree of volatility of the market price. Not only will they guide the trader on when to enter a trade, in case of a narrowing trading range witnessing an imminent breakout, but they can also warn him / her to stay out of a trade.
Elliott Waves will certainly be of great help in spite of their at-first-glance complexity. Not only they assist the trader through the trend's movements, but will also inform him / her about the exact position of the market price within this fractal process. Moreover, they will indicate, through the use of Fibonacci ratios, the logical objective targets for each impulsive / corrective swing and also the probable termination trend level.
The Study of the Pre-Close Period of the prior day's trading zone (at least two hours before close) will reveal valuable information about the next morning's moves and also about strong resistance and support levels. Thus, the morning's end-run zone will be decrypted, and the market price could get unleashed.
The Opening Range is formed by the first low and the first high during the first 15 to 30 minutes of the opening period (refer to Figure 3). Toby Crabel describes more about this great topic in his 1990 book Day Trading with Short Term Patterns and Opening Range Breakout.
If the trader wants to deepen his / her opening range knowledge, Larry Pesavento and Peggy MacKay have developed this concept in their 2000 book titled The Opening Principle: The Best Kept Secret on Wall Street. Among other fascinating tips, we can read the following:
"The opening price will be very near the high or low of that day 70% of the time…Even if it is not the high or the low of the day, the opening price seems to be some kind of harmonic or equilibrium price for that day. The market bounces against the open several times during the day."
The chart in Figure 3 best illustrates this opening principle.
Trading the opening gap by a novice represents a really deadly "Good-Bye Kiss" in "Godfather" Hollywoodian movie style.
However, by strictly applying the techniques described above, the novice's chances of successfully trading the opening gap will greatly improve, with one condition...if he / she protects him / herself with disciplined risk and money management techniques.
Don't neglect this risk protection rule because it often has its revenge, as the rules always do when they are bent or neglected!
*Reprinted (and modified) with permission from Dr. Mircea Dologa. Dr. Dologa, MD, CTA, is a Commodity Trading Advisor and a Stock Investment Advisor (NYSE) and the founder of a new trading concept for newcomers and experienced traders at: www.pitchforktrader.com. He can be contacted at mircdologa@yahoo.com.
