Background
The opening gap trading setup relies on a large downward price gap when the market opens for the day and a retrace of price into that gap. With careful use of entry and exit prices, this is a reliable trading setup, but you should change it to suit your taste and markets.
Methodology
The following figure shows the ideal opening gap trading setup. The vertical line separates the first day
from the second on a 5-minute chart. At candle B, price gaps open lower than candle A which ended trading the prior day. Price may or may not continue
trending downward. If it does, then it’s best that the move down is a strong one, without consolidation regions, candles with small shadows, and little price overlap between bodies.
In this example, price reverses at candle B by forming a tall lower shadow. This is a hint that the bears have begun buying the stock after realizing that it is oversold. The next candle, C, confirms this when it fails to make a new low and the body is white. Use this candle as the signal candle, meaning place an order to buy the stock a penny or two above the candle’s high. The order executes at candle D. Immediately place a stop below the low at candle C (or keep the stop order in your head). If price reverses on you, the stop will cover you.
As price rises, raise the stop but don't keep it too close. When price passes 38% retrace of the AB move then
switch to the 1-minute scale and move the stop to a penny or two below the low of the prior candle. Raise the stop
to the low of the price candle as each new candle forms. For candles with long lower shadows, a stop two candles
back may work better.
Let’s assume that we switched to the 1-minute scale. Price closes lower at candle F but both E and F are small candles. Small candle bodies means indecision:
The bulls and bears are fighting it out to determine direction. The tall upper shadow on candle E suggests that
price is about to reverse, and the black candle at F supports this. At candle F, lower the stop to a penny or two below
candle E, as shown. Candle F gets you out of the stock by tripping the stop.
Checklist
- Find candidates using the Nasdaq-100 heatmap for premarket trading. The page shows a square of stocks, arranged
by how much they have moved premarket and coded by color. Hovering your mouse on a square gives details about
the stock and if you click on a square, more information appears. Here is the link:
http://screening.nasdaq.com/heatmaps/heatmap_pmi.asp
- Use the 5-minute chart for entry, the 1 or 2 minute chart to better time the exit
- Look for a large downward price gap from the prior day
- For profit potential, measure from the prior day’s high to the trend low today then take half of it
- If price continues moving down after the gap, look for few or no consolidation regions, and tall candles with short shadows
- When the candle color changes from black to white and price fails to make a new low, place an order to buy a penny or two above the candle’s high (at candle C in the figure)
- Place a stop a penny or two below the candle’s low
- Follow price upward, raising the stop as appropriate. Use the middle of especially tall candle bodies as the stop location or a few pennies below the low of short candles. If the candles have tall shadows, then place the stop two candles back unless that puts the stop too far away
- When price retraces the prior down move by 38%, then switch to the 1 or 2 minute chart to time the exit
- Use the prior candle’s low (candle E in this example) as the stop location (unless the candle is unusually tall, in which case cut the body in half and use that price)
- Raise the stop as price rises until it takes you out
Example 1
Of the two examples, this one is more successful. Price forms a 4-price doji at A. The next day, price gaps
lower, bottoming at B. Candle C shows a color change so you place a buy order a penny above its top, or 50.74 and
a stop a penny below its low, at 50.60. The target is midway between the high price at A (51.64) and the low at
B (50.51) or 51.08. Remaining
on the 5-minute scale and noticing that candle D is a tall one, you would take half its body height as the stop
price. That would be: 50.90 + (51.21 - 50.90)/2 or 51.06. Candle E takes you out for a profit of 51.06 - 50.60 or
46 cents or $460 on 1,000 shares.
As candle D approaches the price target of 51.08, you switch to the 1-minute scale. If you place a stop below the low of each candle as price climbed, you would have been stopped out at 51.11 for a profit of 51 cents or $510.
Example 2
 The chart shows Alcoa on 10/22/2007 during the opening minutes on a 5-minute chart. Price gaps open lower
from candle A to B, a price range of about $1.10 (37.80 - 36.70). Half of this range would be 55 cents for a target
price of 36.70 + 0.55 or 37.25. Candle C changes color to green, so we place a buy order a penny above its high, or
37.00. The order fills during candle D. This candle rises above the target price (37.25) with a high of 37.27 and
since it's an unusually tall candle, we take half its body height and place a stop there (37.27 - 36.91 = 36 cents
for a body height. Half this is 18 cents added to the open gives a target of 36.91 + 0.18 or 37.09). Candle E stops
us out or you can use the low at E as the stop location. The next candle would stop you out at 37.06.
Once price neared the target, if you switched to the 1-minute scale, you could have narrowed the exit considerably by using
the prior candle low as the exit price. In this case, you would have been stopped out at 37.23 for a profit of 23
cents or $230 on 1,000 shares.
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