Intraday Trading Strategy

A picture is worth a thousand words and nothing will wake you up quite like a morning gap!

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The gap has the amazing ability of taking the breath right out of swing traders and long-term investors as they scramble to assess the pre-market and early morning trading activity.

In this article, we will discuss how to trade morning gaps on the open and how to take advantage of these chaotic situations.

Morning Gap Definition

The morning gap is one of the most profitable patterns that many professional day traders use to make a bulk of their daily trading profits.  The morning gap occurs as a result of the build up in trading activity that occurs overnight due to a economic number, earnings release or company specific news event.

Day Trading Morning Gaps

With the advent of pre-market trading and the ECN’s, trading during non standard market hours has become much more accessible to the public investor; however, this is not to say that the market maker for each security is still not in control.  Market makers are ultimately responsible for creating the market in these securities when there is no bid or ask available and the market can be dramatically shifted especially on the open when they set the market with their orders.  When the equilibrium is skewed in one direction (ie. towards the buyers or sellers), the market maker will open the stock as far as possible in the direction of the skew.  For example, if there is a huge demand on the open for a stock which exceeded the earnings estimates, the market maker will need to create the market by making these shares available from within their own inventory.  Therefore, you can see how it would be advantageous to sell the stock at the highest possible price and buy it at the lowest possible price.  Novice traders will put in market orders to buy or sell on the open and the market makers will legally take advantage of this.  This is why you will see the stock put in a top or a bottom in the first couple minutes of the trading session.

One of the keys to being successful in day trading is being able to ride the coattails of the bigger institutional investors which are able to drive the markets in the direction that they want it to go.  In this series of trading setups, you will understand how to trade with the smart money and stop chasing stocks.

Gap up and Gap Down

Let’s now go deeper in the structure of the gap. If you listen to some of the so-called “sophisticated traders”, they will begin to describe a host of gap types present in the market.

Like everything else on Tradingsim, we will take the simple approach when it comes to analyzing the market and focus on two types of gaps – full and partial.

Full Gaps

We have a full gap when the price opens below or above its previous high or low. In such case the last candle of the previous day and the first candle of the new day do not overlap, hence a full gap.

It is crucial to mention that full gaps have higher volatility and therefore could be considered riskier trades.  Nevertheless, if traded properly, they could lead to attractive results.

Partial Gaps

We have a partial gap when the market opens with a gap but at some point overlaps with the last candle from the previous trading day.

Money Management and Morning Gap Trading

Like every other trading system, gap trading strategies should also include some basic money managementrules. To this point, we will now cover how to set stop loss orders and when to take profits when trading morning gaps.

Stop Loss and Morning Gap Trading

When you want to enter the market after a gap, you need to define your stop loss levels. In other words, you should first decide how much you are ready to lose in case your morning gap system turns against you