Gaps at the Open
Question about Gaps at the Open: If the market opens above your short position or below your long position what do you recommend? When a market gaps open it is very confusing to me.
Answer from an article by Erich Senft: This is an excellent question as gapping markets are a source of concern for many traders. Some traders refuse to trade if a market gaps and opens abnormally high or low, thinking that this is a sign that the market is acting unpredictably. Other traders will take positions opposite an unusually high or low opening, knowing that the market might move away from the opening price. This is known as “fading” the market and is a strategy used by day traders.
How important the opening price is depends a little on your objective as a trader. For instance, if you are a day trader the opening price will hold a lot more importance for you than if you are a position trader who is looking to capitalize on a move that may take several days to realize.
Generally speaking, opening prices are not as important as closing prices. Closing prices usually set the tone for the next session. If a market posted a high closing price (relative to the opening price) and you decided to go long the next day above the high, I would not be overly concerned if the market opened below the entry price. In fact I would prefer it.
If you are planning a long position and the market opens below your entry, then the market has to come to you before your order is filled. By doing this you are essentially making the market prove that you are right before you become involved in the trade. This is a very powerful strategy and one that I try to employ as often as possible.
This assumes of course that you are entering the market on a stop order and not a limit order. If you are using a limit order to go long, and the market opens below you, then you will be filled at the opening price. This scenario is not as desirable as the former as there is the possibility that the market may continue moving lower after the open.
However, by using a stop order and making the market come to you, you can avoid being on the wrong side of the trade if the market does not do as you had hoped. For this reason I always recommend using stop orders to enter the market.
Another scenario is if you are considering a long position and the market gaps above your opening price. When this happens you are faced with a much more difficult decision. Now you need to re-evaluate your trading plan to determine if there is still enough profit potential to offer a good risk/reward ratio before you enter the trade.
As I mentioned at the beginning, some traders will not trade a market that gaps too far above their entry for fear that the market will “fade” and move against their positions. This is not always the case with gaps however. Other times when the market gaps it is a sign that the market is accelerating quickly.
While the day trader may be able to discern between the two, the position trader unfortunately will not know the market’s true intention until the end of the session.
Trust your gut. If you feel unsure about how the market opened then it is probably best to set it aside for the day. But as a rule I try to avoid markets that open beyond my intended entry as this could signal market instability. You might want to read the Open Range Report from the members’ section to see how I determine what an adequate opening range should be.
-Erich
