The major stock indices have tendency revert to the previous day’s closing price in the early minutes of the trading session. This strategy takes its cue from that bit of market behavior.
This intraday strategy, the Morning Gap Reversal (MGR), capitalizes on the major indices’ tendency to retrace toward the prior day’s close each morning. It has a high winning percentage, tested in both bull and bear conditions —an important characteristic for any shortterm strategy — and it is easy to execute.
Each morning the opening price of an index or stock is higher or lower than the prior day’s closing price. This price change is called the morning gap if it is above the previous day’s high (an “up gap”) or below the previous day’s low (a “down gap”). However, for simplicity, we will use “gap” to refer to the distance between the previous close and current open, regardless of whether or not the open falls within the previous day’s range (see Figure 1).
Morning gap statistics
Statistically, price has a very high likelihood of filling between 50 and 100 percent of the gap between yesterday’s close and today’s open during the trading day. Usually, a reversal that fills (or partially fills) the gap will occur within the first 30 minutes of trading (by 10 a.m. ET).
Three years of back-testing from January 1999 to January 2003 on the Dow Jones Industrial Average (INDU), S&P 500 (SPX) and Nasdaq 100 (NDX) indices was conducted to verify the statistical reliability of the basis for the MGR strategy. The analysis was divided into three parts: first, determining the frequency and extent of morning gap reversals; second, finding out how quickly morning gaps reversed; and third, identifying important “time markers” within the reversal period.
Table 1 summarizes the first part of the analysis. The columns show different gap sizes, from 1 to 3 percent (positive or negative). The rows show what percentage of the gaps were filled, and the cells show how often they were filled (at some point during the trading session).
The table shows 85 percent of the gaps between zero and 1 percent in size (positive or negative) closed at least halfway, and 78 percent of the gaps closed between 90 and 100 percent.
Although slightly less reliable, gaps between 1 and 2 percent (positive or negative) showed a similar tendency to be partially retraced or filled. These gaps retraced by at least half 78 percent of the time and retraced between 90 and 100 percent 62 percent of the mornings studied. Gaps in the 2- to 3 - percent range were somewhat less likely to be filled.
Only 14 percent of the gaps (in the “Overall” column) closed between zero and 9 percent, which includes those mornings when price immediately moved in the opposite direction of the gap closure, creating what is known as a “gap and run.”
The second part of the analysis explored how quickly gaps reversed. The gaps typically closed half way (50 percent) by 9:55 a.m. Of the gaps that closed completely, 67 percent of them did so in the first 30 minutes of the trading session, and 86 percent closed by the end of the first hour of trading (10:30 a.m. ET). The likelihood of additional closure declined substantially after the first hour of trading. Gaps that were still open after 60 minutes closed only 4.5 percent of the time. Also, the success rate diminished on days when economic news was released 30 minutes after the market open, at 10 a.m. ET.
The third portion of the analysis identified important time markers during the gap - reversal period.
Figure 2 (below) shows the typical time markers for gap reversals. Just after the open, the major indices tended to continue to move in the direction of the opening price for the first one to 10 minutes. After this initial rally (or sell-off), the market turned and began to close the morning gap. This reversal, on average, began six minutes after the open, at 9:36 a.m. E T. The typical reversal was maximized at 9:53 a.m. ET.
An approximately four minute countertrend move (or “jig,” which often fakes out traders into covering positions early) typically occurred a round 9:42 a.m. and lasted until approximately 9:47 a.m.
Before the bell: Pre-market review process
The first step in trading the MGR is anticipating the direction of the opening move. Usually two hours before the market opens a reliable gap can be identified by checking the pre-market stock index futures quotes on CNBC or Bloomberg T V. Whether these contracts are trading up or down in the early morning can give you an indication of the possible direction of the stock market open.
Second, make note of how the futures are affected in the pre-market by any economic reports released at 8:30 a.m. E T. This will indicate whether the futures are strengthening or weakening in pre-market trading. Make a final check of the futures at 9:10 a.m. (20 minutes prior to the market open).
There are two qualifications for the behavior of the futures in pre - market trading. First, all three index futures contracts (S&P, Nasdaq 100 and Dow) must trade consistently in the same direction during the pre-market. For example, if the Dow futures are down 35 points at 8 a.m. and rally to trade up 20 points by 9 a.m., they have changed from implying a down opening to implying an up opening.
This kind of behavior should not be traded. Similarly, if one contract is up and the other is down (e.g., the Nasdaq is up 5 and the Dow Jones is down 15), it is not a good day to use the MGR strategy.
Second, because a very narrow gap reduces profit potential, gaps in the futures contracts must be in excess of 5 points for the S&P 500 futures, 10 points for the Nasdaq 100 futures and 20 points for the Dow Jones futures.
Other factors
In addition to watching pre-market trading activity, evaluate the support and resistance in the market you intend to trade. Be aware of the projected opening price of the security relative to any significant support or resistance levels.
Often a market that is gapping up will open just under an established resistance level; a market gapping lower might open just above established support.
Both indices and stocks exhibit the morning gap characteristics outlined here. Index-tracking stocks such as QQQ, DIA, or SPY are good vehicles for trading the MGR strategy because, not being subject to the up tick rule, they are easier to sell short than individual equities.
For these reasons, it is recommended that you concentrate on the three major index-tracking stocks when trading the MGR strategy.
Trade entry
The average reversal start time is 9:36 a.m., which means the trade-entry window is generally from 9:30 to 9:42 a.m. If a position has not been initiated by 9:42 a.m., no trade is taken for the day. Three entry techniques can be used with the MGR strategy: time entry, pattern entry and staggered entry.
A time entry consists of “playing the averages” by entering a trade at 9:36 a.m., regardless of what the market is doing at the time. This approach has the advantage of being easy to execute, but it also runs the risk of putting you immediately on the losing side of the market. Despite these disadvantages, a trader without a real -time trading setup system may prefer this method because of its simplicity.
The pattern entry approach waits for the market to reverse toward the previous closing price before entering the trade. The trade is taken only after two complete one-minute bars in the direction of the reversal (i.e.,bars with closes below their opens, and the second bar with a lower low than the previous bar, if the re v e r s a l d i rection is down), as shown in Figure 3). The advantage of this approach is that by waiting for the market to confirm the reversal prior to entry, the trader avoids entering a losing position on days when the market keeps running in the direction of the opening gap. The disadvantage is that the trader is always late getting into the market and may miss significant profits as a result.
The staggered entry combines the first two approaches by bre a k i n g the entry into two equal halves. The first half of the trade is placed at 9:31 a.m. and the second half of the trade is entered after two bearish oneminute bars in the direction of the reversal. This way, if the market reverses quickly, the trader has a partial position already in the market.
However, if the market runs in the dire ction of the open, only half the trade is exposed.
Stop placement
Every trader’s primary focus should be controlling risk and losses. Most traders a requick to take a small profit when the market is willing to give a larger profit, while at the same time they expose themselves to too much initial risk and are slow to take losses. The following guidelines are designed to let the market control your profit while you control your risk.
The strategy uses three kinds of stoploss orders, the sizes of which are intended for SPY, DIA and QQQ. The first type is the “high-low” stop. The primary risk in an MGR trade is the market will continue to run in the direction of the gap. Therefore, if the indextracking stock trades 15 cents above the highest high of the morning (for up gaps) or below the lowest low of the morning (for down gaps) after 9:45 a.m., the position should be closed. This is the worst-case scenario and will yield the strategy’s largest losses.
The second stop-loss is a trailing stop that requires evaluating where the trade is relative to the best price it has experienced up to that point.
First, once a 25-cent profit has been reached, move the stop to breakeven. When a 35-cent profit is in place, trail the stop-loss 25 cents above the highest high (for a short trade) or below the lowest low (for a long trade) reached during the trade.
For example, if the position is up 35 cents and moves back to being up only 10 cents, exit the trade; if the position is up 50 cents and moves back to being up only 25 cents, exit the trade. This approach continually moves the stop in the direction of the trade.
The third stop is the “time stop.” Because this strategy is most successful in the first 30 minutes of trading (and because economic announcements often occur at 10 a.m. ET), the time stop liquidates any position that is still open at 9:55 a.m.. This allows the trader to take advantage of the most beneficial time period without exposing the trade to the volatility of adverse reactions to news.
In actual trading, the majority of losing trades are stopped out with a loss of 50 cents or less. In tests, a 50-cent absolute stop in the SPY and DIA was rarely hit. The lower price of the QQQ made them even less susceptible to being hit; the typical maximum loss in the QQQ is closer to 30 cents than 50 cents.
Position sizing
Correct position sizing will enable you to focus on the strategy without being distracted by unnecessary anxiety. A conservative money management benchmark is to risk no more than 2 percent of account equity on a trade. This means a trading account of $25,000 could aff o rd to risk $500 per trade ($25,000 x .02 = $500). Because this strategy typically stops out a losing trade within 50 cents of the entry, it’s possible to trade up to 1,000 ($0.50 x 1,000 = $500) shares.
Caveats
The stop-loss rules are structured to let the market determine how large the profit should become when the trade runs in the desired direction.
However, when the gap closes entirely before 9:55 a.m., half the position should be closed. (The prior day’s close is a natural resistance/support level; if it is penetrated, the possibility of a turnaround off that level emerges.) The second half of the position should be kept open in case the market continues to move profitably.
Finally, the “jig” mentioned in the statistics section occurs quite fre q u e n t l y between 9:42 and 9:47 a.m. ET. Because this countertrend move can fool a trader into closing a position too quickly, try to avoid closing a position during this time frame. Stick to your original stop-loss levels.
Trade example
Figure 4 shows the Dow Jones Industrial Average tracking stock (DIA) opening higher (on Jan. 23, 2003) than the preceding close, setting up a potential short sale.
Using the simplest entry approach, a short trade was entered at 9:37 a.m. ET at $83.74 (the market was already starting to retrace toward the previous closing price of $83.24). The initial stop-loss was placed at $84.07, which corresponds to the morning high plus 15 cents. (The chart also shows where the pattern entry technique could have been used.)
The market continued to move lower, first reaching the 25-cent profit level at approximately 9:41 a.m., at which point the stop is moved to breakeven. Next, DIA reaches the prior day’s closing price around 9:48 a.m. When this target was reached, 50 percent of the position was closed for a 50-cent profit.
From this point onward, the balance of the position would be exited with the 25-cent trailing stop or at 9:55 a.m., whichever comes first. In this case, the time stop was reached, closing the second half of the trade at $83.47 for a 27-cent profit. The trade’s total profit was just over 38 cents, taking into account the two exits.
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