Trading Morning Session After Significant Gap: Trader Beware

[Dogpile]

This thread is to discuss the difference between trading in the 'morning session' after a significant gap versus a more 'normal' opening price. This is a very important concept.

I post this in the market profile forum because Market Profilers such as Dalton discuss the open with certain desriptions (from Mind Over Markets text):

1. Open Auction In Range -- within previous days high and low
subset to #1:
open 'in balance' -- in the accepted value range of the previous day
open 'out of balance' -- open signifcantly away from the previous day closing price but within yesterdays range

2. Open Auction Out of Range -- the mere fact that the market has opened outside of previous days high or low tells you that short-term traders are not the ones moving the market. this is a market that will be highly emotional. some investors will have made or lost a lot of money and emotional trading will exist as those with big shorts on a gap down could cover/get squeezed and those with big losses could panic.

Linda Rashke uses a 4-pt rule. If S&P futures open is more than 4 pts away from the previous days close -- this is considered a significant gap. note that the last 2 days have seen gaps that are MULTIPLES of this standard rule. It is time to be careful. One standard rule is that expect markets to 'spike' on emotional trading. One interpretation of this is to be careful on 'retracement trades' after a big gap. A retracement trade is a 'pulllback' after a large spike. The market could easily spike in 2-way action and form bull and/or bear 'traps' -- when it breaks (with strong momentum) one way that is a fake before a large move the other way...

[james_gsx]

When you say a retracement trade after a big gap, are you referring to the gap being filled? If so, would the gap fill then be a good place for a pivot trade? I remember John Carter talking about this before, but I would like to hear your input.

[Future]

I think all the text book explanation and strategies about gaps is a little misleading. First, I think its important to understand the reason behind the gap and then read for supply above the opening price and demand below it. In terms of market profile, this would be a open-test drive in which the markets test one direction before reversing to the other.

Luckily for those who traded in 24 hours markets, these "gaps" can be further analyzed by overnight price action. Overnight activity can give out clues as to the signficance of the gap. As a matter of fact, for those trading the US futures that are pretty much "24 hours", I no longer think it is a wise idea to trade off a gap chart. Instead a 24 hour chart is probably better considering all the action that takes place beyond the closing hours. Has anyone done any recent backtesting on gaps and how effective they are fading them now? From my observation, overnight trading has increased significantly over the past years in the S&P and Dow. I would not be suprised if gap plays no longer become as efficient in the near future.

I find it more effective to use overnight resistance and supports instead of playing gaps. Any further expansion is appreciated.

[torero]

I agree, I find agricultures overnight S/R play a big part in the opening hour in direction and reversals. I tend to fade the direction if opening is inside the overnight high/low.

ER2 overnight sentiment and action tend to be ignored. There was a floor trader who mentioned that if the same market that is traded heavily outside the US markets, then overnight S/R tend to be respected. This goes for Ags, forex, crude oil (Amsterdam, London, London, respectively). It makes sense as ER2 is US-centric instrument and not many trade outside the US. I'm not sure about ES, Gold, among others as I don't trade them.

[Dogpile]

<<I find it more effective to use overnight resistance and supports instead of playing gaps.>>

Probably best to look at some examples and talk about specifics. My opening post was just to expect some emotional trading to hit as the cash market opens.

The overnight chart pattern will offer excellent clues and set up a workable structure to trade with.

Certainly one thing that helps is to think about how the last few days have traded and where the open is happening relative to recent structure. Thursday ended with trending action down with price closing 2 std devs below the days VWAP. Thus the 'profile' is 'trending away' from last accepted price (in the 1480's) which continued significantly in the overnight session with action down in the 1440's. At this point, either you are headed for total crash or a period of congestion or a move back up. My point here is just that betting on the crash is really tough location to initiate shorts.

Instead, congestion forms on the globex 24-hour chart and now you have a workable pattern to trade with. This is supported by the general tendency that after a significant gap, the market tends to trade back into the gap.

[BlowFish]

Some random thoughts from my observations.

During the overnight session (from a US perspective) it is the European & Asian markets driving things. Why not watch these rather than the overnight session? Really you are using a 'proxy' for these other markets if you look at the US electronic session. Having said that it is useful to see what levels are established overnight and how they hold next day. Nowadays Europe is every bit as 'powerful' at driving things around. The last few days European markets have been pushing through significant levels before the US opens. Once the US day session starts obviously it opens at this lower level.

Talking of useful levels I have found daily weekly and even monthly charts hugely useful in seeing what has been 'gapped' through. Try looking at a weekly chart, really illuminating. I'll try and post a DAX one for those that don't have Europe data. Its been hugely 'technical'.

Richard Ney has lots to say about gaps and detecting what's real and what's not (though he was talking largely about the NYSE). He alleges the clue is in the predominant trend the previous day, the trend for the last part of the previous day, and the open.

Personally I think support is support and resistance is resistance. When it blows it blows! I am not sure if there is anything to gain by analysing when it blows (i.e. overnight so leaving a 'gap'). I think markets really are becoming truly Global and truly 24 hours though empirically stuff seems to happen less often Asian peak.

Dog, I'd be interested in how you trade differently when a market opens in balance or 'gapped' out of balance?

Cheers.

[Dogpile]

<<During the overnight session (from a US perspective) it is the European & Asian markets driving things. Why not watch these rather than the overnight session? >>

I have the DAX chart on my screen but my problem with it is just that I can't seem to make any sense of that chart. This is something that I keep saying is what I really need to work on. I just don't really understand the dynamics of 'time of day' and the DAX. I would like to learn this but the DAX chart is just a big choppy mess to me most of the time. I do plan on spending more time on this in the near-future as I agree with you in its importance.

In my view, europe does drive action on US markets before maybe 8:30am New York time but Asia is usually just reactive to what happened that day in the U.S. That is my opinion right now, Europe drives early morning, US takes over and then Asia responds to the US action. If asia does something dramatically different than what happened on US markets -- then that is significant -- but this seems to me to be the exception rather than the rule.

Admittedly, trading globex is not my strength -- I generally wait for the cash market to open before I initiate any trades. Part of this is that I have so much 'supporting information' when New York opens that I don't watch on DAX... In US, I watch the adv-decline line, volume vs previous day, put-call ratio, VIX, TICKS, sector movers (brokers), upside/downside volume ratio etc... You also have confirmation between contracts (did YM/NQ/ER2 confirm a new high or new low) etc... All of these things offer clues.

[torero]

From my observation of using tick charts, there is a tendency for the opening to continue the direction previously set from the late afternoon of previous day. The overnight tend to pull back then pull back, or move ahead then pull back at the opening (provided the news at 10AM doesn't bring surprises to change direction and market opinion). One of the setups I trade is to wait the first pivot to be made, and determine if the pivot is a higher low/high (from upward direction of previous day) or lower high/low (downward direction from previous afternoon). It's a not a sure-fire setup, but does provide clues to the probable momentum for the opening. Tick charts with overnight action show this better than regular charts.

[Dogpile]

<<One of the setups I trade is to wait the first pivot to be made, and determine if the pivot is a higher low/high (from upward direction of previous day) or lower high/low (downward direction from previous afternoon). >>

exactly. that is crucial. this is what George Taylor tried to do with the 'Taylor Trading Technique' -- determine if that morning extreme represented a significant high or low for the day. I think this is very similar to what you are doing Torero.

One way to think about it is to think about a diagonal line from the morning session to the afternoon session as the general theme for the day. Is a low being made 'first' or a high being made 'first' (which is the probable direction for the diagonal line)? Then seek supporting information for whatever thesis you come up with.

Bringing this back to the opening gap.. A gap down can be thought of as a slight bias towards thinking a low is being made first. A gap up can be thought of as a slight bias towards a high being made first. Even in many times when this is not the case, you will still get some directional action against the direction of the opening gap for a while and can be positioned for that 'play'. The clear exception is when the market gaps and then shows extreme trending action -- this is signalling potential trend day in the direction of the gap. This is when you need to be careful. Rashke says these happen about 2-3 days per month. But the market will 'fake' the trend day and instead reverse and make a high or low for the day probably 4 times for every trend day that actually does develop. Just have to find set-ups consistent with your thesis and watch your back so you don't get run over.

re Friday... this was big gap down with 'low made first' -- this is consistent with Market Profile that you would expect 'responsive buyers' on a move far below recent 'value'....

Thursday was also a gap down for a trade back up... but note that a high was made first (diagonal line down as the dominant 'theme' for the day). This is where the 'rhythm' of Taylors work really comes in.. Look how the market made a morning low and an afternoon high (low made first) for 3 consecutive days prior to Thursday. You were 'due' for a down day as Taylors concept calls for a 2-3 day cycle in the market where after 3 'low to high' days, you might be looking for a 'high' to be made first. Gaps definitely add to the complexity of this.

[Dogpile]

today in a nutshell (theme for day):

big gap up, high made first (makes morning high), trades from a morning high to an afternoon low (diagonally down).