My System
My gap strategy is based on a Tradestation application that I fondly refer to as "Otis." It is essentially a pattern recognition program that identifies 8 - 12 "high expectancy" gap trade set-ups in the ES per month on average. It is far from perfect and misses many winning trades; however, it misses even more losing trades. By design, it avoids overly large losing trades while taking both long and short trades in all market conditions, and therefore rarely suffers large or lengthy draw downs. It has worked well consistently through volatile and involatile, bear, bull and sideways markets over the past 9+ years. It is this year-to-year consistency that I believe is its greatest strength and that makes it ideal for day-trading, swing accounts, and long-term capital appreciation strategies.
Back-testing "Otis" (v4) using data from 1998 - 2006 shows impressive average annual results with a profit factor of nearly 2.0 and an average win rate of about 70%. These are composite averages consisting of all the signals generated for each of the twelve gap zones during this 9 year period. Historical results almost always exceed real results but I am generally pleased with how my system performed in 2007, a year which will surely go down as one of the most volatile and challenging ever for the markets. As with any system, there is always room for improvement and it could probably be improved by better timing entries and exits using intra-day triggers.
Overview
Zone-Based: All gaps are grouped by recent price action and various support and resistance areas (e.g. OHLC, fibs, pivots, etc.) . I call these areas “zones” and have many of them, each with a sub-zone and optimized targets and stops.
Direction: The vast majority of my gap trades are "fades" (opposite the direction of the gap and in the direction of the prior day's close.) I have two zones in which I will not fade the gap, but rather "go with" and trade in the direction of the opening gap.
Pre-market Filters: My pre-market filters are based primarily on where the gap opens (i.e. zone).
Big Gaps: I do not unilaterally eliminate "pro" gaps (i.e. over 5 - 6 pts), but focus instead on the zone. The larger gaps have lower fill probabilities, but many will finish profitably even if the gap does not fill. Plus, the big gaps provide very nice profits when they work and are a necessary part of my gap system.
Small Gaps: My research also shows that gaps less than 3 pts in select zones should be avoided, because their “profit expectancy” is negative or too low. This is counter to what many gap traders believe.
Position Size: I trade one contract for every $10,000 of equity in my futures account. This ensures that I never suffer a full size loser that exceeds my max allowable money management loss on a single trade, while keeping draw-downs in a range that is psychologically tolerable.
Risk Management: If I get a signal from Otis, but have identified one or more risk factors such as seasonality, proximity to a “go/no go” line, or a zone-specific risk (e.g. weaker performance during bull or bear market conditions), then I will reduce my position size in half.
Stops: All of my stops are optimized for each zone, based upon points or a percentage of the gap amount, whichever is less. For some zones, I use a time-stop and will exit if the gap trade is still open when the stop time is reached.
Targets: Several zones have a high probability of not only filling, but also continuing through the prior day close. Optimizing my target for each zone allows me to maximize profits and take full advantage of smaller gaps that others may pass on. They key is to know which ones to hold for gap fill, beyond the gap fill or to close in front of the gap fill.
Subjectivity: No matter how "ugly" the gap may look, if it meets my criteria I take it. Often the scariest “looking” gaps fill the fastest and visa versa. I try not to move my stop or target once I have placed the trade On occasion, I will tighten the stop as the trade progresses to lock in profits, but I try not to do this during the first half hour when volatility is often highest.
Decision Time: I make my decision on whether to trade an opening gap or not, based upon where prices are trading at 9:25 ET (five minutes before the open of the regular session). Most of the time, I know well before this time, but sometimes I have to wait.
Entry Technique: I enter all gap trades at the cash session open (9:30 ET) using a market order that I place using TradeStation. When I get a signal, I manually setup a time-activated (9:30:00 ET) Market OCO with Entry - Single Order (Short/Long) and with an Exit Bracket - 1 limit & 1 stop level. Occasionally, I will use 2 limits and 2 stops if I think I may be scaling out. Then, I generally leave it alone, letting it fill me at the open and exit at my target or stop. Sounds complicated, but it's really very easy and can be done in less than 1 minute. In fact, I almost always set up my order AFTER I have posted my plan at "Today's Gap Play.
All In & Out: If it gaps into my “zone” then I fade it at the open and place a bracket order for my target and stop. I try not scale out since my research show that profitability is maximized by not scaling out (admittedly this increases draw-downs too); however, I will scale out if I believe that market conditions warrant doing so.
Non-Signal Days: If I do not get a fade signal for the opening gap, I use my "non-signal" historical probabilities (which I also post at "Today's Gap Play") and sometimes back-test the current gap profile to determine the probability of it filling that day or not (note: some gaps have a high probability of filling but are difficult to optimize using one set of criteria. Others are not likely to fill at all.) I like to know this before the day starts as it often provides me an edge for an intra-day trade.