Understanding gaps

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Understanding Gaps
Profi ti ng from the openi ng gap

S c ott A ndrews
“TheGapGuy”

i

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Copyright© 2008 by Master the Gap, Inc. All rights reserved.
Printed in the United States of America. No part of this publication may be reproduced or transmitted,
in any form or by any means; electronic, mechanical, photocopy, recording or otherwise, without the
prior written permission of publisher.
ISBN 10: 1-934674-01-X
ISBN 13: 978-1-934674-01-7
Edited by Edward Dobson
Disclaimer
Trading and investing has large potential rewards and large potential risks. You must be aware 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 intended for educational purposes only and is believed to be accurate, but neither the author
nor publisher makes any warranties regarding its accuracy. 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 in this book. The
past performance of any trading system or methodology is not necessarily indicative of future results.
The author asks that you use this information at your own risk!

Published by Traders Press, Inc.®
PO Box 6206
Greenville, SC 29606
www.traderspress.com
Contact us:
(800) 927-8222


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Purpose of This Book

Whether you are interested in adding the opening gap to your daily trading plan or just improving
the timing of your entries in swing trades and long term investments, this guide can help. By the
end, you should have a basic understanding of gaps, a structure for creating a profitable strategy,
some helpful probabilities and tips, and a little inspiration to help you get started.

iii

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Publ
i
s
he
r
’
sFor
e
wor
d
Understanding Gaps

Understanding Gaps is part of an ongoing series of publications of Traders Press Inc®.
Ea
c
hbooki
nt
hi
ss
e
r
i
e
si
si
nt

e
nde
dt
opr
ov
i
det
r
a
de
r
swi
t
ha
n“
u
p-c
l
os
e
”l
ooka
tat
opi
c
which has had little i
nde
pt
hc
ov

e
r
a
g
ei
not
he
rt
r
a
di
ngr
e
l
a
t
e
dl
i
t
e
r
a
t
u
r
e
…a
ndt
opr

ov
i
dea
source of additional information as well as a listing of other sources and articles from
which the reader may learn more about the topic covered.
The idea for this latest addition to ou
r“
Un
d
e
r
s
t
a
n
d
i
n
g
…”series was born when I
had the pleasure of meeting Scott Andrews at the New York Traders Expo in February
2008. It became readily apparent from our conversation there that he had spent a great
deal of time and effort studying opening gaps, a topic about which I had seen little written
and which I felt would of great interest and value to fellow traders. In my opinion, Scott,
“
TheGa
pGu
y
”
,

i
soneoft
hewor
l
d’
sf
or
e
mos
te
x
pe
r
t
song
a
psa
ndhowt
he
ymi
g
htbe
profitably traded.
It is our hope that his research and comments on gaps will help you to advance
your skills and knowledge as a trader, and will prove a valuable resource to your trading
library.

Edward Dobson, President
Traders Press, Inc.
Greenville SC

May 21, 2008

iv

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Tabl e of Contents
INTRODUCTION

1

Why I Love Trading Gaps

2

WHAT ARE GAPS?

4

The Basics

4

How To Use & Profit from Gaps

10

The Promise of Gaps

11

The Paradox

11

CREATING A PROFITABLE STRATEGY

13

Gap Size

13

Gap Zone

14

Seasonality

15

Stop Size

16

Target Optimization

18

REAL WORLD EXAMPLES

20

How I Trade Gaps

20

Gap Fade Examples

22

“GoWi
t
h”Exampl
e

35

“Fadet
heFi
l
l
”Exampl
e

37

GAP TRADING TIPS

39

GET STARTED!

41

Conclusion

44

GLOSSARY

46

BIBLIOGRAPHY

49

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chapter

Introduction
Trading for a living is a lot like flying a helicopter in combat. The stakes are high
and the risks are everywhere. The enemy can shoot you down, the aircraft can
malfunction, or you can simply make a mistake and crash and burn on your own. I
learned how to fly at the U.S. Army Aviation Warfighting Center at Fort Rucker,
Alaba
maa
n
dI
’
l
ln
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rf
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ti
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ac
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l
’Vi
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a

nwi
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hab
i
gs
o
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r
nd
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a
wl
,“
I
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lt
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dt
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wt
of
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”Be
l
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eme; he
was no
tt
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r
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og
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e
for my survival.
When I committed to becoming a full time trader, the parallels between learning
how to fly and learning how to trade were quite obvious. The keys to success were
threefold: 1) master the fundamentals, 2) start slow, and 3) above all else,
SURVIVE the learning curve. So, I enrolled in a rigorous, monthly training
program with a credible trading and options mentor. My goal was to learn
everything I needed to know in order to generate enough profits per month using
my cash assets so that I could make a living as a trader.
Though I followed his system and rules precisely, I struggled with consistency.
Because his approach was completely indicator-based and heavily reliant upon
options, it was impossible to back-test and, therefore, I never knew if any given loss
was due to my execution (i.e. interpretation of the charts) or was simply an
unavoidable loser. (Using the flying analogy, it was sort of like having an accident

a
n
dn
o
tk
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o
wi
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gwh
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ec
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o

r
”o
ra
ne
n
g
i
n
ema
l
f
u
n
c
t
i
o
n
.
)
Further, having significant sums of capital at risk in volatile stocks for weeks or
more at a time was driving me crazy. Just like a helicopter pilot flying an airplane
for the first time, I kept “
o
v
e
r
-c
o
n

t
r
o
l
l
i
n
g
”b
ytinkering with my trades (i.e. cutting

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the winners short) in an attempt to reduce risk and lock in profits. This, of course,
r
e
s
u
l
t
e
di
nt
h
ec
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a

s
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el
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p
h
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t
.
”
After two years, it was clear: this proven but highly subjective methodology was a
t
e
r
r

i
b
l
ef
i
tf
o
r“
me
.
”I k
n
e
wh
o
wt
o“
f
l
y
”
,b
u
tIn
e
e
d
e
dt
of

i
n
da
n“
aircraft”better
suited for my personality. So, I went looking for a style and approach that would
work for my strengths (structured and mathematically inclined), my weaknesses
(impatient and limited trading experience), and desired lifestyle (flexibility during
the day without having to watch screens all day –Id
i
d
n
’
twa
n
ta
n
o
t
h
e
r“
j
o
b
.
”
)
Ultimately, this led me to the world of gap trading, and specifically, the opening gap
of the S&P 500® futures.

Why I Love Trading Gaps

Trading gaps is not for everyone. But for me, I consider the opening gap, the ideal
trade setup. They occur almost daily, offer plenty of profit opportunity, and are
normally short term in nature (1-2 hours). Gap trading offers many other
compelling benefits including:
1)

Gaps have an inherent bias and edge: over 72% of all gaps in the S&P 500
futures market have filled the same day over the past ten years.

2)

They occur frequently (three to four tradable gaps per week in the S&P) so
I am not reliant upon catching that "one big winner" to achieve my monthly
goals.

3)

It's an easy trade to learn and play. No need to "time" the entry - just use a
market order at the open.

4)

I can prepare in about 15 minutes before the market opens each day. No
need to scan hundreds of stocks at night.

5)

I can trade them without charts and from anywhere.

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6)

Getting filled with minimal slippage is not an issue –especially in highly
liquid markets like the equity indices and futures markets (S&P 500,
NASDAQ 100, etc.).

7)

The target is pre-defined so I don't have to manage the trade after placing it
(though sometimes I do to maximize profits).

8)

My risks are controlled and limited to a small percent of my account. No
overnight risk.

9)

Gap trades work in bull and bear markets equally well. I don't need to
predict the mar
k
e

t
’
sn
e
x
t
mo
v
e
.

10) They occur in most asset classes (equities, futures, currencies, etc.) and can
be traded using stock, options, and futures contracts.
11) I can grow my account several percent per month on average, and often
more with this single, simple setup using just one market. No need to
baby-sit lots of different markets waiting for that perfect, entry-sensitive
trade to appear.
12) Understanding the bias of the market before and after the gap fills,
provides a trading edge for the rest of the day while also helping optimize
my entries on swing and position trades.
I am not the only one who recognizes these many benefits. James Altucher, in the
first chapter of his book, Trade Like a Hedge Fund, states:
“Th
eg
a
pt
r
a
d
ei

st
h
eb
r
e
a
da
n
db
u
t
t
e
rt
r
a
d
ef
o
rmany day traders and hedge
f
u
n
d
s
.
”
The opening gap in the S&P futures is the single most significant daily event in the
global equity markets. It is, therefore, arguably the most important trade of the day.
Because I trade the E-Mini S&P 500® futures for a living, most of my examples

and research are based upon this index. However, the fundamentals of gap trading
shared in this book can be applied to gaps in any market.

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chapter

What Are Gaps?
The Basics

Th
emo
s
tc
o
mmo
nd
e
f
i
n
i
t
i
o

no
fa“
g
a
p
”i
st
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ed
i
f
ference between an asset or
instrument’
so
p
e
n
i
n
gp
r
i
c
ea
n
di
t
sp
r
i

o
rd
a
yc
l
o
s
i
n
gp
r
i
c
e
.Th
i
sd
i
f
f
e
r
e
n
c
es
h
o
wsu
p

v
i
s
u
a
l
l
yo
nat
e
c
h
n
i
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a
lp
r
i
c
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h
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r
ta
sa
no
p
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ns

p
a
c
eo
r“
g
a
p
.
”Ma
n
yma
r
k
e
t
sn
o
w
trade nearly 24 hours a day electronically; however, the bulk of volume is transacted
d
u
r
i
n
gt
h
e
i
r“

r
e
g
u
l
a
r
”t
r
a
d
i
n
gh
o
u
r
s(
i
.
e
.
o
p
e
no
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t
c
r

yo
rp
i
ts
e
s
s
i
o
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o
u
r
s
,
e
.
g
.
9
:
3
0
–
16:15 ET for the S&P 500)
.Fo
rt
h
i
sr

e
a
s
o
n
,
t
h
er
e
g
u
l
a
rs
e
s
s
i
o
n
’
so
p
e
na
n
dc
l
o

s
i
n
g
prices carry great significance for most traders and their systems. (Note: some
traders define a gap as the difference between the prior day high or low and the next
d
a
y
’
so
p
e
n
i
n
gp
r
i
c
e
.However, the research and examples presented in this text are
based on the difference between the open and the prior day close.)
Gaps occur for a variety of reasons, including geopolitical activities, earnings
announcements, economic reports and related events that transpire during nonregular trading hours. These events often trigger significant price movement away
from the prior day closing price, resulting in an imbalance of supply and demand
the next morning. The regular session opening price represents a critical time for all
market participants since they have to decide whether to accept or reject this new
price. The majority of the time prices will retrace some or all of the overnight price
a

c
t
i
o
nd
u
r
i
n
gt
h
ef
o
l
l
o
wi
n
gd
a
y
’
st
r
a
d
i
n
gs
e

s
s
i
o
n
.I
ft
h
ep
r
i
c
er
e
t
r
a
c
e
sa
l
l
t
h
ewa
yt
o
t
h
ep

r
i
o
rd
a
yc
l
o
s
i
n
gp
r
i
c
e
,
t
h
eg
a
pi
sc
o
n
s
i
d
e
r

e
dt
oh
a
v
e“
f
i
l
l
e
d
”o
r“
c
l
o
s
e
d
.
”
Many traders seek to profit from the tendency of prices to retrace the overnight
movement by trading in opposite direction of the open. This is commonly known as
“
fading the gap.
”Figure 1 shows an example of an opening gap in the E-Mini S&P
500 f
u
t

u
r
e
s
.Th
e“
p
r
i
o
rc
l
o
s
e
”i
st
h
el
a
s
tt
r
a
d
ea
so
f4
:
1

5p
.
m.ETo
ft
h
ep
r
e
v
i
o
u
s
d
a
y
’
sr
e
g
u
l
a
rt
r
a
d
i
n
gs

e
s
s
i
o
n
.Th
e“
opening price”is the first trade at the market
open at 9:30 a.m. ET. Note how prices on the five minute chart climb steadily
4

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shortly after the open, retracing b
a
c
kt
ot
h
ep
r
i
o
rd
a
y

’
sc
l
o
s
e
,b
e
f
o
r
er
e
v
e
r
s
i
n
g
sharply and trading lower for the remainder of the session.

Figure 1. Example of Opening Gap that “
Fi
l
l
s
”(
i
.

e
.
r
etraces overnight move)
Since gaps are the result of human behavior reacting to a variety of market forces,
the subsequent price behavior often develops into a pattern that is repeated again
and again. The four most common gap patterns are:

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Figure 2: Breakaway Gap, 2-27-07.
Breakaway Gaps. These gaps occur after a period of price consolidation. They
are caused by a surge of demand to buy or sell the market, typically in response to a
significant event. The gaps are not filled during the same trading day (often not for
many days or weeks) and are associated with above average volume. See Figure 2.

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Figure 3. Common Gap, 3-7-08.
Common Gaps. Th

e
s
eg
a
p
so
c
c
u
rt
h
r
o
u
g
h
o
u
tama
r
k
e
t
’
st
y
p
i
c
a

le
b
ba
n
df
l
o
wi
n
response to a wide variety of events and news. They are often associated with
average or below average volume and generally fill the same day. See Figure 3.

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Figure 4. Continuation Gap, 4-18-01.
Continuation / Runaway Gaps. These gaps occur during, and in the direction of,
ano
n
g
o
i
n
gt
r
e

n
da
n
da
r
eg
e
n
e
r
a
l
l
yv
i
e
we
da
sc
o
n
f
i
r
ma
t
i
o
no
fat

r
e
n
d
’
ss
t
r
e
n
g
t
h
.
They are associated with above average volume and often do not fill the same day.
See Figure 4.

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Figure 5. Exhaustion Gap, 1-22-08.
Exhaustion Gaps. These gaps occur at or very near the end of a trend. They are
typically associated with very high volume as the very last buyers (or sellers if the
asset is in a downtrend) jump aboard a trend that is ending and are overrun by
opposing market forces as prices stall and often reverse sharply that day. See Figure
5.

The challenge, of course, is being able to recognize the type of gap early enough in
the trading day so that you can trade it appropriately and profitably. Many traders
use volume to help identify the type of gap, but this can be tricky since large volume
may not appear until late in the session.

9

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How to Use & Profit from Gaps

Traders and investors pay attention to gaps for different reasons. Many traders
“
f
a
d
e
”(
i
.
e
.t
r
a
d
ei
nt

h
eo
p
p
o
s
i
te direction) Common and Exhaustion Gaps by
b
u
y
i
n
g“
d
o
wn
”g
a
p
so
rs
e
l
l
i
n
g(
i
.

e
.
s
h
o
r
t
i
n
g
)“
u
p
”g
a
p
sa
n
dt
a
r
g
e
t
i
n
gt
h
ep
r

i
o
rd
a
y
’
s
closing price. Their objective is to profit from the historical tendency of gaps to
retrace the overnight move and to close out at the end of the day if the gap has not
filled. Swing traders look to the do the same, but in conjunction with other analysis
that lends them to believe that the gap is an Exhaustion Gap and the reversal may be
the beginning of a multi-day or multi-week move. Swing traders will also use
Breakaway and Continuation Gaps as opportunities to enter trends in the direction
of the gap.
Generally speaking, day traders will enter a gap fade immediately at the market
open or sometime shortly after the open. Swing traders will do the same if they
believe the gap could be an Exhaustion Gap and they want to get positioned for a
potential move in the opposite direction. They will enter a Common Gap after
prices retrace and fill the gap, or after it is clear that it is a Continuation or
Breakaway Gap that will not fill that day and a multi-day trend is likely beginning.
This text wo
n
’
tc
o
v
e
rt
h
emy

r
i
a
do
fe
n
t
r
yt
e
c
h
n
i
q
u
e
su
s
e
db
yd
a
ya
n
ds
wi
n
gt
r

a
d
e
r
s
;
however the bibliography at the end includes an excellent source of articles and
books that delve into a wide range of common and not so-common techniques.
While gaps occur in most markets, many traders prefer to play them using a broad
i
n
d
e
xs
u
c
ha
st
h
eSt
a
n
d
a
r
d& Po
o
r
’
s5

0
0
® (S&P 500) or Dow Jones Industrial
Index® instead of an individual equity or commodity. The reason is simple: a
d
i
v
e
r
s
i
f
i
e
db
a
s
k
e
to
fs
e
c
u
r
i
t
i
e
sma

yb
el
e
s
sl
i
k
e
l
yt
o“
g
a
pa
n
dr
u
n
”s
i
n
c
ei
ti
sl
e
s
s
prone, in theory, to a single specific news item causing a sustained move.
Investors can benefit from paying attention to gaps too. Dr. Harry Schiller, a

columnist for the TheStreet.com, may have said it best in video-taped interview at
the June, 2007 Moneyshow (paraphrased):

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‘
Gaps define the markets' action, especially the S&P futures gap, on an intraday,
daily, even monthly basis... very, very often. Whatever you are buying, you will do a
better job, be more effective and more profitable, if you buy as those gaps are
getting filled. People who don't pay attention to gaps, are just missing the boat!
’
The Promise of Gaps

Gaps are important to traders of all types and time-frames because of their frequent
occurrence and strong, proven tendencies to fill the same day. The S&P 500 index
is a good benchmark because it represents a wide range of equities and sectors. The
table in Figure 6 shows the results of hypothetically fading more than 2,000 opening
gaps (> 1 point), using no stop, in the E-Mini S&P 500 futures from January 1, 1998
through April 30, 2008.No
t
e
:“
Wi
n%”i
sd

e
f
i
n
e
da
st
h
epercent that hit the gap fill target
(i.e. prior day close) or finished the day profitably.

Year
2008*
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
Total:

Number of
Gaps
79*
225
200

196
213
211
229
208
223
236
226
2167

Win %
72.2%
64.9%
72.5%
71.4%
72.3%
75.4%
73.4%
74.0%
73.5%
75.9%
73.0%
72.6%
(average)

* January 1 - April 30, 2008

Figure 6. Gap Fade Win Rate (using no stop), 1998-2008.
The Paradox
With such a proven bias to fill the gap, it would seem logical for traders to just fade them

all since roughly three out of four should be winners, right? Not quite. Figure 7 shows that
using no stop, targeting the gap fill and closing out at the end of the day if the gap has not
f
i
l
l
e
d
,
r
e
s
u
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t
e
di
nma
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r
o
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)
.

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Year
Profit Factor
2008*
1.24
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:
1.08
* January 1 - April 30, 2008
Profit factor = total gross profits / total gross losses

Figure 7. Gap Fade Profitability (using no stop), 1998-2008.
Clearly, this is not a very profitable strategy since the gross profits were barely
greater than the gross losses. The paradox lies in the fact that a stop loss must be
used in order to protect profits from the 25-30% of gaps that do not fill, and that
o
f

t
e
nmo
v
ea
g
g
r
e
s
s
i
v
e
l
yi
nt
h
ed
i
r
e
c
t
i
o
no
ft
h
eg

a
pa
n
do
p
p
o
s
i
t
eo
fy
o
u
r“
f
a
d
e
.
”
You may trade a series of smaller gaps that fill successfully, only to watch that one
large gap continue running away, taking your account and profits right along with it.
Thus, trading gaps poses a difficult dilemma: what size stop loss should be used? If
the stop is too tight (i.e. small) then the trader risks being stopped prior to the gap
f
i
l
l
i

n
g
.I
ft
h
es
t
o
pi
st
o
ol
a
r
g
e
,t
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et
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r
’
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o

s
s
e
swi
l
le
r
a
s
es
o
meo
ra
l
lo
ft
h
e
profits from the winners.
There is no simple answer, but a multi-dimensional approach that integrates gap
selection, reasonable stops, and optimized targets can create a very profitable gap
trading strategy for any market. We
’
l
ls
t
a
r
tt
op

u
tt
h
e
s
ep
i
e
c
e
st
o
g
e
t
h
e
ri
nt
h
en
e
x
t
chapter.

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chapter

Creating a Profitable Strategy

Whether you are day trader seeking to profit from fading an opening gap or a swing trader
looking to optimize your position entry, the first key for success is being able to identify
those gaps that are most likely to fill (i.e. common or exhaustion gap vs. continuation or
breakaway gap). Gap size, gap zone, and seasonality are three elements of gaps that
provide helpful clues for choosing winning setups and building a successful trading
strategy.
The examples that follow are all based on the S&P 500 Index futures market. However,
traders may apply this framework and analysis to any market to develop a gap trading
strategy.
Gap Size
Perhaps the most common method for analyzing gaps and their probability of filling the
same day is to use the size of the gap. Figure 8 shows the win rate of fading various size
opening gaps in the E-Mini S&P 500 futures index from 1998–
2007. As you might
expect, the smaller the gap, the more likely it was to fill or finish the day profitably. The
tradeoff, of course, is that smaller gaps have less profit potential and one large gap loser can
wipe out a whole string of small winners.
Gap Size As
Percent of
Index
<.2%
.2 - .4%
.4 - .6%

.6 - .8%
.8 - 1%
1 - 1.5%
> 1.5%

Win %
84.5
71.7
64.8
63.9
58.6
49.1
58.9

Figure 8. Gap Fade Win % by Size of Gap, 1998 -2007.
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Gap Zone

Location. Location. Location. In doing research on gaps to develop my strategy, I
identified a series of “
g
a
pzones”that have a clear impact on the probability that a
given gap will fill. These zones refer to the location of the gap relative to the prior

d
a
y
’
sdirection and key price levels: Open, High, Low, and Close. Figure 9 shows
the average win rates by zone, for fading opening gaps > 1 point in the E-Mini S&P
500, using no stop, and closing at the end of the day if the gap did not fill.

Gap Zones
If Prior Day Is Down
High

Open

Win %
59%

66%

If Prior Day Is Up
High

CLOSE

75%

CLOSE

Win %
71%

82%

75%

Open

78%
Low

72%
Low

65%

54%

Copyright © 2008 by MasterTheGap.com. All Rights Reserved.

Figure 9. Average Win Rate by Gap Zone, 1998 –2007.
The gap zone dimension is very powerful since it inherently incorporates gap size,
prior day trend, and trader psychology. Although it may seem a little counterintuitive on the surface, it is actually quite logical. For example, a gap up above the
h
i
g
ho
fap
r
i
o

r“
u
p
”d
a
y(
i
.
e
.p
r
i
o
rd
a
y
’
sc
l
o
s
e was greater than its open) may be
more likely to attract profit taking at the first sign of resistance, than a gap up above
t
h
eh
i
g
ho
fap

r
i
o
r“
d
o
wn
”d
a
y(
i
.
e
.p
r
i
o
rd
a
y
’
sc
l
o
s
ewa
sl
e
s
st

h
a
ni
t
so
p
e
n
)wh
i
c
h
would be counter to the prior day trend and may be more likely to attract new
buyers and short covering. The probabilities in Figure 9 demonstrate this by
s
h
o
wi
n
gt
h
a
tf
a
d
i
n
gg
a
p

sa
b
o
v
et
h
eh
i
g
ho
fp
r
i
o
r“
u
p
”d
a
yh
a
v
eamu
c
hh
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g
h
e
rwi

n

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rate historically (71%) than fading gaps above the high of a prio
r“
d
o
wn
”d
a
y
(59%).
Tip: You can expand the concept of “
gap zones”to include the
preceding several days (or more) of price action to identify
patterns with even higher probability and/or profit expectancy.
Seasonality

“
Seasonality”(i.e. historical tendencies based upon various calendar criteria) is
another helpful tool to filter gap setups. Some days and months clearly offer better
odds of success than others. Figures 10 and 11 show the win rate of fading gaps in
the E-Mini S&P 500 by day of the week, and by month. Notice how overall win
rates tend to be higher in the middle of the week and how success rates vary by

direction of the gap fade as well. May and September, traditionally transitional
months for traders heading into, and returning from, summer vacations, produces
the lowest overall win rates.

Monday
Tuesday
Wednesday
Thursday
Friday

# Gaps

Total
Win %

Long
Win %

Short
Win %

377
392
400
390
384

70.8%
74.0%
76.5%

73.9%
72.4%

69.5%
77.2%
72.1%
74.4%
70.3%

71.9%
70.9%
80.5%
73.4%
73.9%

Figure 10. Win Rate by Day of Week, 1998 –2006.

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Month

#
Gaps

Total

Win %

Long
Win %

Short
Win %

January
February
March
April
May
June
July
August
September
October
November
December

155
134
174
158
167
157
170
169
158

180
166
154

73.6%
77.6%
72.4%
74.7%
70.1%
75.8%
75.3%
72.8%
63.9%
77.8%
76.5%
72.1%

71.4%
75.9%
74.0%
72.3%
66.2%
78.7%
71.3%
68.7%
63.1%
81.3%
77.5%
72.9%

75.0%
79.0%
71.0%
76.3%
73.1%
73.2%
78.9%
76.7%
64.9%
73.4%
75.6%
71.4%

Figure 11. Win Rate by Month, 1998 –2006.
Tip: Seasonality studies can also be expanded to day of the
month (1-31) and even zone-specific seasonality. A word of
caution: be sure that the number of gaps in your evaluation is
statistically significant (e.g. > 30) and be careful not to overoptimize.

By combining gap size, direction, zone, and seasonality, gap traders can
dramatically increase their success in selecting winning gap fades. Though certainly
not foolproof, a significant edge can be gained versus other market participants who
are less well informed.
Stop Size

Gap selection is only half the battle in creating a profitable gap strategy. The other
half is choosing the optimal size stop and target price. This is where it can get a
little tricky and counter-intuitive for strategy development. The smaller your stop
loss (i.e. risk), the lower the win rate and vice versa: the bigger the stop loss, the
higher the win rate. The key is to balance the two at a point that provides optimal

profit expectancy within your individual risk tolerance.

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Figure 12 shows the historical win rates and profitability for fading gaps > 1 point
in the E-Mini S&P 500, using stop losses based upon a percentage of the size of the
gap.
Stop As
% of Gap
Size

% Win

Average
Win/Loss
Ratio

25%
21.4
3.49
50%
36.0
1.80
75%
47.0

1.18
100%
53.7
0.91
125%
59.0
0.73
150%
61.8
0.64
175%
64.7
0.57
200%
66.1
0.53
Note: 1998 –2007, E-Mini S&P 500 futures.

Profit
Factor
0.95
1.01
1.05
1.06
1.05
1.04
1.05
1.03

Figure 12. Win Rate and Profit Factor by Size of Stop (Percentage of Gap Size).

For example, per Figure 12, fading a 4 point gap in the E-Mini S&P futures using a
2 point stop, would have only been profitable approximately 36% of the time
historically, with an average profit almost twice that of the average size loss. Losing
2 points twice for every time you would make 4 points would result in a breakeven
strategy and hence the profit factor of 1.01 as shown in the table.
I trade the opening gap in the E-Mini S&P 500 and find it easier and more effective
to simply use a fixed number of points as a stop for each gap zone. I do not vary the
size of the stop based upon the size of the gap since Figure 12 shows this is
generally not effective or profitable. (Note: profitability can be enhanced by using
stops tailored for each zone since some require bigger/smaller stops than others.)
Each point for a futures contract equates to a specific dollar amount. For the E-Mini
S&P one point is equal to $50.00 per contract. Figure 13 shows win rate and
profitability when using stops based on a number of price points in the E-Mini S&P
500.

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Stop
Size
Profit
(pts)
% Win
Factor
1
23.5

0.85
2
39.2
1.04
3
48.8
1.11
4
55.5
1.13
5
60.1
1.15
6
63.5
1.15
7
66.2
1.17
8
67.4
1.13
9
68.6
1.11
10
69.4
1.09
12
70.8

1.10
14
71.6
1.07
16
71.8
1.05
18
72.0
1.03
20
72.2
1.02
Note: 1998 –2007,
E-Mini S&P 500.

Figure 13. Win Rate and Profit Factor by Size of Stop (Points)
Target Optimization

Many traders only focus on gap selection and stop size when developing their
strategies; however, target optimization can make a significant difference in the
profitability of your gap trading strategy. In fact, I consider target optimization to
be a critical component of my success. If I am in a winning trade and gaps into that
zone have a proven historical tendency of continuing through the gap fill, why
would I want to cut my profits short? I would not a
n
dt
h
a
t

i
swh
yIu
t
i
l
i
z
e“
e
x
t
e
n
d
e
d
t
a
r
g
e
t
s
”(
b
e
y
o
n

dt
h
ep
r
i
o
rd
a
yc
l
o
s
e
)f
o
rma
n
yo
fmyg
a
ps
e
t
u
p
s
. The table in
Figure 14 shows the win rate when targeting ẳ, ẵ, ắ, and full gap fills, as well as
points beyond or through the gap fill, over the past ten years.

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Target as
% of Gap
Size

Win %

25%
89.7%
50%
83.5%
75%
77.2%
100%
72.8%
125%
67.9%
150%
65.1%
Note: 1998 –2007,
E-Mini S&P 500.

Figure 14. Win Rate Using Targets Based Upon Percentage of Gap Size.
Tip: Some “

gap z
ones
”ar
ees
pec
i
al
l
ypr
onet
ot
r
adi
ngt
hr
ough
the gap fill price, so be sure to look for these extended target
opportunities when developing your strategy. The trade-off in
win rate versus profit expectancy can be quite good.

Perhaps you are thinking you could simply choose the optimal gap profile (by size,
zone, and seasonality), target ¼ gap fill, and use a reasonable stop, and you will be
swimming in profits right? If only it were that easy. This approach will indeed
result in a gap strategy that will have a very high win rate. But, it will likely make
little, if any, actual profits since the average size loss will greatly exceed the average
size winner.
The name of the game is to be selective in choosing gaps to fade and to utilize stops
and targets that generate maximum profits long term with an acceptable win/loss
r
a

t
i
oa
n
d“
d
r
a
wd
o
wn
”r
a
t
i
ofor your trading style and account equity. If you are
new to gap trading, creating a profitable strategy may seem a bit overwhelming, but
hang in there. The next chapter will demonstrate a variety of real world examples.

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