Gap Trading Techniques
1. Morning Reversal Strategy

2

2. Trading The Overnight Gap

6

3. Trading The Opening Gap

12

4. Gap Closer

16


TRADING Strategies

Morning REVERSAL strategy
Historical tests reveal the tendency of the major stock indices to 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.
BY BRYAN C. BABCOCK AND ARTHUR AGNELLI

F

inding a strategy that backtests successfully is rare; finding one that is reproducible in
live trading is rarer still.
The following 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).
First, we will analyze the behavior of
morning gaps to determine if they provide a logical basis for a trading strategy.

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
FIGURE 1 MORNING “GAPS”: REVERTING TO THE CLOSE
divided into three parts: first, deterIn the first half-hour of the trading session, the market will frequently retrace in
mining the frequency and extent of
the direction of the previous day’s close.
morning gap reversals; second, finding out how quickly morning gaps
S&P 500 index-tracking stock (SPY),
88.97
reversed; and third, identifying
one-minute
88.92
important
“time markers” within
88.88
the reversal period.
88.84
88.80
Table 1 summarizes the first part
88.76
of the analysis. The columns show
Market open price
88.72
different gap sizes, from 1 to 3 per88.68
cent (positive or negative). The rows
88.64
88.60
show what percentage of the gaps

88.56
were filled, and the cells show how
88.52
often
they were filled (at some point
88.48
during the trading session).
88.44
Reversal
88.40
The table shows 85 percent of the
88.36
gaps between zero and 1 percent in
Gap up
88.32
size (positive or negative) closed at
88.28
least halfway, and 78 percent of the
88.24
88.20
gaps closed between 90 and 100 per88.16
cent.
88.12
Although slightly less reliable,
Prior day close
88.08
gaps between 1 and 2 percent (posi88.04
88.01
tive or negative) showed a similar
1/22 15:40 15:45 15:50 15:55 1/23 9:35 9:40 9:45 9:50 9:55 10:00 10:05 10:10

tendency to be partially retraced or
Source: Great-Trade by Protrader
2

www.activetradermag.com • May 2003 • ACTIVE TRADER


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

TABLE 1 MORNING GAP ANALYSIS
direction of the
The columns show morning gaps of different sizes.
opening price for
The
rows indicate how much of the gaps were filled.
the first one to 10
minutes. After
Gap size
this initial rally
%
of
gap
closed
+/-1%
+/-1
to
+/-2%
+/-2 to +/-3% Overall

(or sell-off), the
0-9
12
8
19
14
market turned
and began to
10-19
0
2
5
2
close the morn20-29
1
6
5
2
ing gap. This
30-39
1
4
6
2
reversal, on aver40-49
1
2
5
1
age, began six

50-59
2
5
2
1
minutes after the
60-69
1
7
4
2
open, at 9:36 a.m.
70-79
2
1
4
2
ET. The typical
80-89
2
3
2
2
reversal
was
90-100
78
62
48
72

maximized
at
50%
85
78
60
79
9:53 a.m. ET.
An approximately
fourminute countertrend move (or “jig,”
futures quotes are also available through
which often fakes out traders into coverthe Chicago Mercantile Exchange Web
ing positions early) typically occurred
site, www.cme.com.) Whether these conaround 9:42 a.m. and lasted until approxtracts are trading up or down in the early
imately 9:47 a.m.
morning can give you an indication of
the possible direction of the stock market
Before the bell:
open.
Pre-market review process
Second, make note of how the futures
The first step in trading the MGR is antic- are affected in the pre-market by any
ipating the direction of the opening
economic reports released at 8:30 a.m.
move. Usually two hours before the marET. This will indicate whether the
ket opens a reliable gap can be identified futures are strengthening or weakening
by checking the pre-market stock index
in pre-market trading. Make a final
futures quotes on CNBC or Bloomberg
check of the futures at 9:10 a.m. (20 min TV. (Minute by minute pre-market index

utes prior to the market open).

FIGURE 2A MORNING UP-GAP TIME MARKERS

FIGURE 2B MORNING DOWN-GAP TIME MARKERS

The primary time “milestones” in early trading show the
retracement to the previous close typically maximizes
around 9:53 a.m.

The time markers for the typical down gap are the same
as those for up gaps.

Morning open — up gap

Prior day
closing price

Morning peak on average
9:36 a.m. EST

Trade is maximized
9:53 a.m.

Price “jig” — usually
9:42-9:47 a.m.
Trade is
maximized
9:53 a.m.


Prior day
closing price

Morning open — down gap

ACTIVE TRADER • May 2003 • www.activetradermag.com

Price “jig” —
usually
9:42-9:47 a.m.
Morning bottom
on average
9:36 a.m. EST

3


FIGURE 3 PATTERN ENTRY
One way to enter a trade is to wait for two consecutive bars that close lower than
they open (in the case of a downward reversal and potential short trade), with the
second bar also having a lower low than the first bar

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
88.97
S&P 500 index-tracking stock (SPY), one-minute
in the direction of the reversal (i.e.,

88.92
bars with closes below their opens,
88.88
88.84
and the second bar with a lower low
88.80
than the previous bar, if the reversal
88.76
direction is down), as shown in
88.72
Figure 3). The advantage of this
88.68
approach is that by waiting for the
8
8
.
6
4
Pattern entry:
88.60
market to confirm the reversal prior
consecutive bearish
88.56
to entry, the trader avoids entering a
one-minute bars in the
88.52
losing position on days when the
direction of the reversal.
88.48
market keeps running in the direc88.44

tion of the opening gap. The disad88.40
88.36
vantage is that the trader is always
88.32
late getting into the market and may
88.28
miss significant profits as a result.
88.24
The staggered entry combines the
88.20
first two approaches by breaking
88.16
88.12
the entry into two equal halves. The
88.08
first half of the trade is placed at 9:31
88.04
a.m. and the second half of the trade
88.01
1/22 15:42
15:46
15:50
15:54
15:58
16:02
16:06
16:10
16:14
16:18
16:22

16:26
1/23 9:32
9:36
is entered after two bearish oneSource: Great-Trade by Protrader
minute bars in the direction of the
reversal. This way, if the market
reverses quickly, the trader has a
There are two qualifications for the open just above established support.
partial position already in the market.
behavior of the futures in pre-market
Both indices and stocks exhibit the
However, if the market runs in the directrading. First, all three index futures con- morning gap characteristics outlined
tion of the open, only half the trade is
tracts (S&P, Nasdaq 100 and Dow) must here. Index-tracking stocks such as
exposed.
trade consistently in the same direction QQQ, DIA, or SPY are good vehicles for
during the pre-market. For example, if
trading the MGR strategy because, not
Stop placement
the Dow futures are down 35 points at 8
being subject to the up tick rule, they are
a.m. and rally to trade up 20 points by 9
easier to sell short than individual equi- Every trader’s primary focus should be
a.m., they have changed from implying a ties. For these reasons, it is recommend- controlling risk and losses. Most traders
are quick to take a small profit when the
down opening to implying an up opened that you concentrate on the three
market is willing to give a larger profit,
ing. This kind of behavior should not be major index-tracking stocks when tradwhile at the same time they expose themtraded. Similarly, if one contract is up ing the MGR strategy.
selves to too much initial risk and are
and the other is down (e.g., the Nasdaq is

slow to take losses. The following guideup 5 and the Dow Jones is down 15), it is Trade entry
lines are designed to let the market connot a good day to use the MGR strategy.
The average reversal start time is 9:36
trol your profit while you control your
Second, because a very narrow gap a.m., which means the trade-entry winrisk.
reduces profit potential, gaps in the
dow is generally from 9:30 to 9:42 a.m. If
The strategy uses three kinds of stopfutures contracts must be in excess of 5 a position has not been initiated by 9:42
loss orders, the sizes of which are
points for the S&P 500 futures, 10 points
a.m., no trade is taken for the day. Three
intended for SPY, DIA and QQQ. The
for the Nasdaq 100 futures and 20 points entry techniques can be used with the
first type is the “high-low” stop. The
for the Dow Jones futures.
MGR strategy: time entry, pattern entry
primary risk in an MGR trade is the
and staggered entry.
market will continue to run in the direcOther factors
A time entry consists of “playing the
In addition to watching pre-market trad- averages” by entering a trade at 9:36 a.m., tion of the gap. Therefore, if the indexing activity, evaluate the support and regardless of what the market is doing at tracking stock trades 15 cents above the
highest high of the morning (for up
resistance in the market you intend to the time. This approach has the advantage
gaps) or below the lowest low of the
trade. Be aware of the projected opening
of being easy to execute, but it also runs
morning (for down gaps) after 9:45 a.m.,
price of the security relative to any sigthe risk of putting you immediately on the
the position should be closed. This is the
nificant support or resistance levels.

losing side of the market. Despite these
worst-case scenario and will yield the
Often a market that is gapping up will disadvantages, a trader without a realstrategy’s largest losses.
open just under an established resistance time trading setup system may prefer this
The second stop-loss is a trailing stop
level; a market gapping lower might method because of its simplicity.
4

www.activetradermag.com • May 2003 • ACTIVE TRADER


that requires evaluating where the
FIGURE 4 SHORT-TRADE EXAMPLE
trade is relative to the best price it
In this case, the entire morning gap was filled in the first 20 minutes of trading,
has experienced up to that point.
at which point half the trade was liquidated and a 25-cent trailing stop was used to
First, once a 25-cent profit has been
protect the remainder.
reached, move the stop to
breakeven. When a 35-cent profit
84.274
Dow Jones Industrial Average index-tracking
Initial stop-loss is placed at the
is in place, trail the stop-loss 25
84.20
stock (DIA), one-minute
morning high plus 15 cents
cents above the highest high (for a
84.16

8
4.12
short trade) or below the lowest
84.08
Pattern
entry
84.04
low (for a long trade) reached dur84.00
(Two consecutive one-minute
ing the trade.
83.96
bars
in
the
direction
8
3.92
For example, if the position is
83.88
Exit remainder of
of
the
reversal)
83.84
up 35 cents and moves back to
position at 9:55 a.m ET 83.80
being up only 10 cents, exit the
83.76
(83.47)
Entry:

83.72
trade; if the position is up 50 cents
8
3.68
Price — 83.74
83.64
and moves back to being up only
Time — 9:37 a.m. ET
83.60
25 cents, exit the trade. This
83.56
83.52
approach continually moves the
83.48
83.44
stop in the direction of the trade.
83.40
The third stop is the “time
83.36
83.32
stop.” Because this strategy is
83.28
8
3.24
most successful in the first 30 min83.20
utes of trading (and because eco83.16
83.12
Exit 50 percent of the position (at 83.24) when
nomic announcements often occur
83.08

the entire morning gap is closed.
83.04
at 10 a.m. ET), the time stop liqui83.01
1/22
15:30 15:35 15:40 15:45 15:50 15:55 1/23
9:35
9:40
9:45
9:50
9:55
10:00
dates any position that is still open
at 9:55 a.m.. This allows the trader
Source: Great-Trade by Protrader
to take advantage of the most benHowever, when the gap closes entiretechnique could have been used.)
eficial time period without exposing the
ly before 9:55 a.m., half the position
The market continued to move lower,
trade to the volatility of adverse reacshould be closed. (The prior day’s close first reaching the 25-cent profit level at
tions to news.
is a natural resistance/support level; if it approximately 9:41 a.m., at which point
In actual trading, the majority of losing trades are stopped out with a loss of is penetrated, the possibility of a turn- the stop is moved to breakeven. Next,
around off that level emerges.) The sec- DIA reaches the prior day’s closing price
50 cents or less. In tests, a 50-cent
ond half of the position should be kept around 9:48 a.m. When this target was
absolute stop in the SPY and DIA was
open in case the market continues to
reached, 50 percent of the position was
rarely hit. The lower price of the QQQ
move profitably.

closed for a 50-cent profit.
made them even less susceptible to being
Finally, the “jig” mentioned in the staFrom this point onward, the balance of
hit; the typical maximum loss in the
tistics section occurs quite frequently
the position would be exited with the 25QQQ is closer to 30 cents than 50 cents.
between 9:42 and 9:47 a.m. ET. Because cent trailing stop or at 9:55 a.m., whichevthis countertrend move can fool a trader
er comes first. In this case, the time stop
Position sizing
was reached, closing the second half of
Correct position sizing will enable you into closing a position too quickly, try to
to focus on the strategy without being avoid closing a position during this time the trade at $83.47 for a 27-cent profit. The
frame. Stick to your original stop-loss trade’s total profit was just over 38 cents,
distracted by unnecessary anxiety. A
levels.
taking into account the two exits.
conservative
money
management
benchmark is to risk no more than 2 perStatistical foundation
cent of account equity on a trade. This Trade example
Figure 4 shows the Dow Jones Industrial and tight risk control
means a trading account of $25,000
Average tracking stock (DIA) opening The MGR strategy is based on the favorcould afford to risk $500 per trade
higher (on Jan. 23, 2003) than the precedable statistical performance of early
($25,000 x .02 = $500). Because this strategy typically stops out a losing trade ing close, setting up a potential short morning reversals back to the previous
day’s closing price. It combines a high
within 50 cents of the entry, it’s possible sale.
Using the simplest entry approach, a
winning percentage with conservative

to trade up to 1,000 ($0.50 x 1,000 = $500)
short trade was entered at 9:37 a.m. ET at
risk management.
shares.
$83.74 (the market was already starting
The strategy’s simplicity makes it
to retrace toward the previous closing
easy to monitor and “paper-trade” in
Caveats
price of $83.24). The initial stop-loss was
real-time, which lays the groundwork
The stop-loss rules are structured to let
placed at $84.07, which corresponds to for actual trading. Ý
the market determine how large the
profit should become when the trade the morning high plus 15 cents. (The
chart also shows where the pattern entry For information on the authors see p. 12.
runs in the desired direction.
ACTIVE TRADER • May 2003 • www.activetradermag.com

5


TRADING Strategies

Trading the overnight
With increasingly reactionary markets

GAP

comes the higher risk of opening gaps.

Learn how to spot the early warning signs
and how to take advantage of them.

BY DAVID S. NASSAR

I

n today’s markets, many stocks
can have large supply-demand
imbalances at the opening bell.
Often, these imbalances result in
what are known as gaps, when the opening price is higher or lower than the preceding close.
News, in various forms, is generally
the catalyst for gap openings. The most
common type is macroeconomic news
such as FOMC meetings, the release of
economic indicators such as unemployment or the Consumer Price Index (CPI),
or stock-specific news such as earnings
surprises or analyst upgrades or downgrades.

When buying interest exceeds selling
interest, the gap will obviously be to the
upside and vice versa. However, what is
not known is the price level at which the
stock will open, and the precise risks
associated with being long or short in a
particular situation.
Until recently, these price levels were
often determined exclusively by large
“off-floor” markets, such as Instinet, an

institutional trading network that was
the first outside-market-hours trading
medium. Today, with the advent of
many other Electronic Communications
Networks (ECNs), there are many more
retail traders active in pre- and postmarket trading. However, even though
the public has access to the pre-market,
the levels that trade pre-market are still
mostly influenced by market makers
who bid or offer stock at price levels
away from the previous day’s close
when imbalances appear in their automated systems.
Because many of these imbalanced
orders are “market on open orders”
(meaning they are to be executed at the
“best” available price as soon as the mar-

ket opens), market makers have an
incentive to open a stock at extreme levels directly correlated to the imbalance.
This simply means that if an imbalance
is on the demand side, and a given stock
is going to open strong, market makers
will open it as high as they can, taking
the opposite side of the trade on open
buy orders.
Because most members of the public
trade only the long side of the market,
many unsuspecting amateurs buy into
gap-up openings at what often will be
the high price of the day. As a result, it is

worthwhile to explore the possibility of
trading situations when a gap will not
hold (reverses), rather than those
instances when the stock follows
through with a move in the same direction. Whether the stock reverses and
closes the gap or follows through in the
same direction, this move is perhaps the
strongest indication of what the trend
will be for the stock shortly after the gap
opening. In the example of bullish gaps,
stocks that fail to meet new highs from
the opening levels will have a greater
likelihood to retrace and lose much of

The first clue that a stock is ripe for a gap opening
is an increase in volume over its normal daily average.
6

www.activetradermag.com • March 2001 • ACTIVE TRADER


FIGURE 1 CHARGING LOWER
Starting in September 2000, the uptrend in Intel (top chart) came to a halt,
punctuated by a series of downside gaps. Typically viewed as a blue-chip stock
free of extreme volatility, Intel became much more volatile after the first
down gap; it became a "charged" stock that propelled the entire semiconductor
sector lower (bottom chart).
the opening gap.
Conversely, stocks that remain
strong and trade to new highs after the

opening gap will have a greater likelihood of following through and trending higher. While this shouldn’t be
interpreted too rigidly (there are other
indicators to monitor, such as index
strength and sector strength, etc.), it is
the strongest single indication of how a
stock will trade following a gap opening.
Regardless of whether gaps are to
the upside or downside, it is important
to study the impact they have on
stocks. The following components and
considerations are most important
when trading gaps:

Intel (INTC), daily

75
70
65
60
55
50
45
401⁄32
39
35
300,000,000

Volume

200,000,000


28

• Charged stocks/sectors;
• Volume and volatility;
• Chaos and over-activity;
• High risk (elasticity).

5
Sept.

11

18

25

2
Oct.

9

16

23

30
Nov.

6


13

1200.00
1150.00
1100.00
1050.00
1000.00
950.00
900.00
850.00
800.00
750.00
700.00
651.22

PHLX Semiconductor Sector Index (SOX), daily

Let’s look at each of these factors.

Where the action is:
Charged stocks and sectors
Once a sector is in the public eye, think
of the component stocks as being
pumped up or “charged.” When this
occurs, the volume in the stock will
increase, and there will be a tremendous swing in the trading range from
one session to the next, either to the
upside or downside. Before the opening bell, in the absence of actual trade
activity, market makers will predict

price pattern changes — either slightly
before an event or immediately after one
— and bid the stock higher or lower
based on their predictions.
If a major stock within a sector experiences negative or positive news, it can
charge an entire sector. Figure 1 shows
Intel (INTC) gapping down after negative news on inventories. The entire
Philadelphia semi-conductor index
(SOX) became charged and volatile

21

28

Sept.

5

11

18

25

2
Oct.

9

16


23

100,000,000
74,009,300
0

30
Nov.

6

13

600.00

Source: QCharts by Quote.com

immediately after. As you can see from
the chart, Intel did not hold its levels
after the first gap and followed through
by trending lower, as did the SOX index.

Early warning signs:
Volume and volatility
The first clue that a stock is ripe for a gap
opening is an increase in volume over its
normal daily average. Often, the volume

ACTIVE TRADER • March 2001 • www.activetradermag.com


increase will occur before the news is
known. This is an indication that news is
leaking in the market and explains the
cliché “stocks tell their own story” ahead
of news. Remember, the biggest trading
houses often have strong indications of
sector and stock strength/weakness
before the media. Therefore, when
increases in daily volume accompanied
by directional bias are seen in the
7


absence of news, a gap is generally not
far behind.
The best way to track volume is by
knowing the average daily volume for
the stock or sector in question, in combination with its key trading levels (support or resistance). Watching the time
and sales ticker is an excellent way to

heavy buying and selling, which result
in small price movements until one side
ultimately gains control. Once a clear
imbalance is revealed, whether bullish
or bearish, the volume tends to dry up as
market participants start to lean over to
one side of the supply/demand scale.
For example, if the bulls gain control at a


get whipsawed out of trades, taking
many losses. Certainly, you also need a
clear picture of what the broader price
action looks like before even thinking
about adding volatile, big-range stocks
to your watchlist. It is also important to
dramatically lower your size in these
trades, because the range of the price

Stocks tend to overreact and move to extreme price levels,
which sets up the possibility
of a correction in the next trading session.
monitor changing volume for short-term
intraday trades. If the ticker is moving
fast, you are seeing an increase in volume — it’s that simple.
When this occurs, you are generally
looking at a “vertical spread” (VS) situation. A high VS means the price pattern
is changing rapidly, up or down, and
you will need to “lead” the market (i.e.,
place a limit order that is the best bid or
offer) to buy or sell as the range widens.
A slower-moving issue that has a tight
“horizontal spread” (HS), where the
spread between the bid and ask is tight,
say 1⁄16, will not require leading. If the
stock has a tight HS, you can easily “lift
offers” or “hit bids” — or even buy bids
and sell offers –— during tight price
range situations.
To spot volume changes that may lead

to gaps, it is important to take a broader
view of both the volume and the market
itself. Notice the dramatic volume
increase in Intel over the course of several days, in Figure 1. However, the volume interpretation changes within each
move and the stock will move the most
on the least volume once it is in motion.
For example, when stocks are growing
weaker, panic and fear is heightened and
fewer buyers are stepping up. Therefore,
as buyers disappear from the market,
stocks fall harder on light volume and
with a wider range before new support
levels are found. Once the stock establishes support levels, the volume builds
dramatically as buyers remain strong,
while sellers are still in the market. It is
at these levels that the true battle
between bulls and bears takes place.
These campaigns are evidenced by
8

key support level, buyers will exceed
sellers and the stock will trade higher on
less volume as the buyers lift thin offers
at each price level.
The lesson here is that volume indicates where the battles are fought
between bulls and bears, but once a
dominant bias is revealed, the stock will
move the most on lighter volume. Gaps
are the ultimate example of this: no volume exists, but extreme price change
does. Once this gapping action begins,

chaos is not far behind.

Chaos and high risk:
Are gaps worth it for you?
Chaos reaches its peak when stocks have
no real support or resistance levels in
sight. For example, if a stock is not well
supported until it trades 20 points lower,
volatility will be extreme.
These such conditions represent a
day-trading environment only. This is
not a time to take overnight positions.
Remember, volatility can also be defined
as chaos and, therefore, you can throw
your technical tools and indicators out
the window. If you want to day trade in
this climate, you must take a micro view
of the stock, taking small incremental
profits and losses vs. trying to trade the
overall trend.
Also important is that gaps often
reveal the beginning of new trends.
However, if you’re a longer-term position trader in these situations, you must
have a much higher risk tolerance
because these price fluctuations are part
of the equation. Otherwise, you will constantly employ “discipline” at the wrong
time (placing stops too close, etc.) and

swings offsets the trade size needed to
profit.

Seeing the broader view of the market
is like a hurricane: When you’re in it, it is
chaos, but if you can get far enough
away, you can see the larger pattern and
direction. When you trade chaotic
stocks, you must trade them accordingly
or avoid them altogether.
To determine if a chaotic market climate in general, and the overnight-gap
trade in particular, is for you, ask yourself the following questions:
1. Do I have the account size required
to take the necessary risk?
2. Do I have the temperament and
the required level of risk tolerance?
3. Am I “in the money” and willing
to take on additional risk for
additional reward?
4. Do I have clarity and confidence
enough to see the gap coming?
5. Did I day trade this stock the entire
day prior to the anticipated gap?
If you answered “no” to any of these
questions, don’t even think about taking
the trade. If you answered “yes” to all of
the questions, then you have the criteria
to attempt it. Here’s how to do it.

Taking the trade
Let’s begin with the fact that, because of
volatile price pattern movements during
the day, stocks will tend to overreact or

overtrade, moving to extreme price levels that are extreme. This sets up a possible correction for the next trading session, when market makers will often gap
the stock price to levels that are advantageous for them.
The first gap that sets the stock in

www.activetradermag.com • March 2001 • ACTIVE TRADER


FIGURE 2 EARNINGS DISAPPOINTMENT
Leading up to the earnings release on Oct. 27, shares of American Power Conversion (APCC) traded from 18 to 22 in
five days. The earnings didn’t live up to expectations and the stock gapped nearly seven points lower the following day.
American Power Conversion (APCC), 10-minute
22
21
20
19
18
17
16
15
14
13 1⁄16
Volume

1,000,000
500,000
255,300

11 12 13 14 15

0

10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11 12 13 14 15 10 11
10/20 Friday
10/23 Monday
10/24 Tuesday
10/25 Wednesday
10/26 Thursday
10/27 Friday
10/30 Monday

Source: QCharts by Quote.com

motion because of unforeseeable news is
generally not predictable. However, the
gaps that may follow can occur for some
of the following reasons:
• Additional news, such as earnings
releases.
• Short squeezes and profit taking
(“hook” closes).
• S&P 500 futures volatility.
These different factors can provide
various signals that offer opportunities
for gap trades.
Earnings. Earnings are perhaps the
most significant factor regarding gap
trades, because they have such a substantial impact on both stocks and sectors.
The market is far more unforgiving of
missed earnings than it is rewarding to
earnings that meet estimates. Many companies meet expectations and still get
hammered the day after their announce-


ments. This is because most positive earnings expectations are built into the stock
price in the days prior to the report. For
this reason, stocks have a greater propensity to fall when companies merely meet
expectations.
When expectations are missed, the
downside bias is dramatic. Therefore,
you should rarely take an overnight
position in a company that is reporting
earnings after the close. If you do, your
natural bias should be to trade the short
side — especially in this market environment, where good earnings are often no
match for inflationary pressure, rising
interest rates and oil prices.
Because so many stocks have an
upside bias in the days prior to an earnings report, it is best to sell into the news
if you’re long the stock, and wait for the
outcome. Figure 2 is an example of what
companies experience when they miss

ACTIVE TRADER • March 2001 • www.activetradermag.com

expectations.
Short squeezes and profit taking.
Short squeezes and profit taking are the
most common reasons stocks will tend to
build above-average volume into the
close and cause what is called a “hook”
close.
In a short squeeze, a stock is in a

downtrend and market makers suspect
there may be many short sellers in the
market. The squeeze and the hook occur
when the professionals begin to buy the
stock rapidly into the close, causing price
to rise swiftly and forcing the short sellers to cover in a panic. Profit taking generally occurs when a stock is in a rising
trend but shows a weak close accompanied by high volume. At this point,
traders with long positions begin to sell
the stock to take a profit. Figure 3 shows
an example of a short squeeze, while
Figure 4 is an example of a hook formed
9


FIGURE 3 SHORT SQUEEZE
On Oct. 26, Amgen (AMGN) closed the day near its high on a sudden spurt of buying that was likely the result of a short
squeeze. A look at the intraday chart reveals the stock was in a downtrend, with the previous support level at 69 1⁄2
becoming resistance.
Amgen (AMGN), 5-minute

72

70

68

66

64


62

60
59 1⁄8
1,200,000
1,057,900
1,000,000

Volume

800,000
600,000
400,000
200,000
12

13

14

15

10
11
10/25 Wednesday

12

13


14

15

10
11
10/26 Thursday

12

13

14

15

0
10
10/27 Friday

Source: QCharts by Quote.com

during profit taking.
If you’re not in a profitable situation
from day trading the stock, you should
not take the overnight gap trade. It is
best to stand aside and trade the open
the following day, after the stock gaps
open — if it does. If you had a profitable
day-trading session, you can take the

overnight position if you think the riskreward relationship is satisfactory.
Remember, when going after an
overnight position, it must always be
with purpose and confidence. Never

hold a losing position overnight, hoping
the stock will “come back.” That is nothing but gambling.
S&P 500 futures. S&P 500 futures are
an important consideration when taking
an overnight gap trade. You should look
at the correlation between the futures
market and the index in relation to the
gap-trading plan you have in mind. If
the futures are moving decisively higher
going into the close, and you have other
independent reasons for the stock in
question to gap higher the next day, and

The first gap that sets the stock
in motion because of unforeseeable news
is generally not predictable.
10

all other questions and factors can be
answered favorably, you could keep
your long position overnight.
The point is you must have clarity and
confirmation on all levels when taking a
position overnight. Still, the most significant piece of information comes from
the stock itself and how it behaved while

you where trading and watching it in the
days prior to the anticipated gap.
Without this information, you will not
be able to make a decision whether to
take a gap trade or not.
Gap trading is a risky business, and
the professionals who quote stocks up or
down prior to the open have a vested
interest in doing so. If you were a market
maker who made your living buying and
selling stocks from the public while providing liquidity to the market, where
would you open a stock with poor news
knowing you were to receive market on

www.activetradermag.com • March 2001 • ACTIVE TRADER


FIGURE 4 PROFIT-TAKING
Transwitch Corp. (TXCC) was on its way to recovery from a sell-off in the fiber optic group. Along the way, profit taking
on Oct. 30 forced the price lower at the end of the day. The next morning the stock gapped higher, with the buyers
once again firmly in control.
Transwitch Corp. (TXCC), 5-minute

56 5⁄16
56
54
52
50
48
46

44
42

Volume

200,000
150,000
100,000
50,000
8,200

14

15

10

11

12
13
10/27 Friday

14

15

10

11

12
10/30 Monday

13

14

15

10

11
12
10/31 Tuesday

Source: QCharts by Quote.com

open orders? You would open it as low as
possible, where you felt the stock was
well supported. This is known (from the
market maker’s perspective) as “buying
weakness.”
Conversely, with strong news, knowing you would be selling at the open,
where would you open the stock? The
higher the better, so that you could short

stock to buyers at what would be a significant resistance level. This is referred
to as “selling strength.”
This is why gaps have a greater propensity to close immediately after the
open: After the initial panic selling or

mania buying has been gobbled up by the
market maker or specialist, a vacuum
often develops and the stock will reverse.

By contrast, if the stock continues to follow-through in the direction of the gap, it’s
a strong indication that the trend will continue.
Remember, however, that while these
rules are good to use as a guide, they
should not be traded with indiscretion.
There are many factors that impact any
individual gap-trading situation. Ý

The market is far more unforgiving of missed earnings
than it is rewarding to earnings that meet estimates.
You should rarely take an overnight position in a company
that is reporting earnings after the close. If you do,
your natural bias should be to trade the short side.
ACTIVE TRADER • March 2001 • www.activetradermag.com

11


&

FUTURES

Trading Strategies

OPTIONS


Trading the

OPENING GAP

Watching pre-market volume is a good way to determine whether
to trade or fade the opening move.

BY JOHN CARTER

O

pening price gaps — the
distance between the regular-session opening price
and the previous day’s
closing price — are stomach-churning
events when the market makes a big
move against you, but they represent
low-risk trade opportunities if you know
which gaps are likely to be followed by
predictable patterns.
In terms of the price behavior that follows opening gaps, not all markets are
created equal. Gaps in individual stocks
and commodities do not act the same as
TABLE 1 FILLING THE OPENING
GAP: RAW DATA
Between Jan. 15, 2002, through
February 2004 (528 occurrences),
an average of 76 percent of all
opening gaps closed at some point
during the same day. This is the

breakdown by day of week. Adding
the pre-market volume filter
increased the percentages.
Day

Percentage of
gaps filled

The best markets for gap plays
The S&P 500 and the Dow are the best
markets to trade the opening gap

because of the diversity of their component stocks. Both indices represent collections of stocks from different industries
that are more likely to react independently to news events. In the technologyheavy Nasdaq, opening price gaps can
take longer to fill because the majority of
the stocks will react similarly to news.
The key to trading opening gaps is
being able to predict the likelihood a
particular gap will be filled. Dissecting
the market conditions that produce a
gap is as important as analyzing a gap
itself. For example, an opening gap following high pre-market cash trading
volume can take weeks to get filled
because high volume increases the odds
the market will continue to move in the
direction of the gap.
Some of the biggest gaps are caused
by major news events, such as the outbreak of a war, but gaps caused by minor
news items are much more common.
Generally, such gaps are smaller, fill

quickly (see Table 1) and can be “faded”
(the act of trading against the direction
of the gap) more effectively. Let’s look at

TABLE 2 TRADE MANAGEMENT GUIDELINES
The higher the volume, the greater the likelihood the market will continue
in the direction of the opening gap. As a result, no trade is taken when vol ume is above 70,000.

Monday

65%

Pre-market volume
in key stocks

Tuesday

77%

Less than 30,000

Full size

Exit entire position at gap fill

Wednesday

79%
82%


Between
30,000 and 70,000

2/3 size

Thursday

Exit half at 50 percent of gap
fill, half at gap fill

Friday

78%

Above 70,000

Source: Tradethemarkets.com
12

those in “multi-item” instruments such
as stock indices because a news item will
control the entire market instead of just a
portion of it. Earnings announcements,
corporate scandals and other companyspecific events can create gaps in a component stock’s chart that never get filled.
Because of the unpredictable nature of
various events that can impact the price
of an individual stock, they make poor
candidates for the opening-gap trade.
In contrast, stock index futures such as
the E-mini S&P (ES) or the mini-sized

Dow (YM) are better candidates for
opening-gap plays because they consist
of multiple components that respond differently to news. For example, although a
stock index futures contract may gap up
on a news item, there will be individual
stocks within the index that will either
ignore the news or sell off. This weighs
the index down and creates a trade
opportunity as the market fills the gap.

Position size

No “fade” trade

Trade target

No “fade” trade

Source: Tradethemarkets.com
www.activetradermag.com • December 2004 • ACTIVE TRADER


the specific criteria for identifying those
gaps with the best chances of reversing.

The pre-market volume indicator
The most important indicator for determining which opening gaps can be
faded is the pre-market volume in a specific set of stocks.
Check the pre-market volume at 9:20
a.m. ET (10 minutes before the regular

cash session opens) in the following
stocks: KLA-Tencor Corporation (KLAC),
Maxim Integrated Products, Inc. (MXIM),
Novellus Systems, Inc. (NVLS) and
Applied Materials, Inc. (AMAT). These
representative stocks were selected
through a trial-and-error process.
If the market is really set up to move,
there will be significant volume in the
cash market in pre-market trading. If the
market is setting up for a “head fake” (a
move in one direction that is quickly
reversed), pre-market volume will be
low, which reflects a lack of conviction in
the move. This is the preferred setting
for an opening-gap trade.
If the pre-market stocks have each
traded less than 30,000 shares at this
time, analysis of the prior 500 trading
days shows the opening gap, up or
down, had an 80-percent chance of filling the same day. However, if the volume for each stock is between 30,000
and 70,000, the gap only has about a 60percent chance of filling that day, while
the midpoint of the gap has an 85-percent chance of being hit.
Finally, if the pre-market volume for
each stock is above 70,000, the chances of
the gap filling that day drop to 30 percent. In these cases, you should ignore
the news and follow the direction of the
gap. Table 2 provides guidelines for
using volume information to manage
trades. As the volume increases, the

position size shrinks and the profit-taking becomes more conservative.
If one stock has volume above 70,000
but the others are below the threshold,
check to see if the news pertains to this
company alone. If it does, ignore it. If the
news is not specific to the company,
trade the more conservative position.

The strategy
Figure 1 is a five-minute chart of the

If the market is poised to move, there
will be significant pre-market volume
in certain stocks.
mini Dow futures. You can use any time
interval — a one-minute, five-minute or
15-minute chart, etc. — as long as you
can view the opening. This means the
chart must be set up to reflect the opening and closing of the regular trading
session, 9:30 a.m. to 4 p.m. ET (4:15 p.m.
for stock index futures prices). Many
traders are used to watching a separate
chart of the continuous 24-hour futures
session, but of course, opening gaps

the Dow gapped up 47 points as a result
of a positive earnings report from Intel
(INTC). On this day, pre-market volume
was below 30,000.
As a result, the appropriate trade is to

immediately short the gap on the open
using a full position size, as indicated in
Table 2. To keep things simple, we’ll use
nine contracts as a full position, which
makes a two-thirds position six contracts
and a one-third position three contracts.

FIGURE 1 THE OPENING GAP
This 47-point-plus opening gap in the mini Dow futures was filled in the first
hour of trading for a $235 per-contract profit.
9,830

Mini Dow futures (YM), five minute

9,820
Gap is filled for a 47-point
gain, or $235 per contract
(47 points x $5 per point).

9,810
9,800
9,790
9,780
9,770
9,760
9,750
9,740
9,730
9,720
9,710

10/15/03

11:00

12:00

13:00

14:00

15:00

9:00

9,700

10:00

Source: eSignal

won’t show up.
Figure 1 shows the first day in a set of
back-to-back earnings announcements
that caused opposite reactions in the
market. On the morning of Oct. 15, 2003,

ACTIVE TRADER • December 2004 • www.activetradermag.com

We will use a $100,000 account, which
means we are trading one contract for

each $11,100 in the account for a full position. Although you can trade a mini Dow
or E-mini S&P contract with only a few
13


&

FUTURES

OPTIONS

Trading Strategies continued

FIGURE 2 THE DAY AFTER
One day after the trade setup shown in Figure 1, the mini Dow contract
opened lower, setting up a long trade.
9,800

Mini Dow futures (YM), five minute

9,790
Gap filled for a 61-point
gain, or $305 per contract.

9,780
9,770
9,760
9,750
9,740
9,730

9,720
9,710
9,700

10/16/03
15:00
9:00 10:00
Source: eSignal

11:00

12:00

13:00

14:00

FIGURE 3 EMOTIONS TRIGGER GAP
The E-mini S&P futures made a downside opening gap on Aug. 2, 2004, on terrorist
threats. The market spent most of the day filling the gap.
E-mini S&P 500 continuous contract (ES), five minute

1,106
1,105

Close on 7/30/04:
1,103.75

1,104
1,103

1,102
1,101
1,100
1,099
1,098
1,097

Open on 8/2/04:
1,097.00
14:45 15:0515:25 15:45

Source: TradeStation

14

8/2

1,096

10:00 10:2010:4011:00 11:20 11:4012:00 12:20 12:40 13:00 13:2013:40

thousand dollars, this trading plan controls risk by limiting exposure relative
to the amount of available capital.
Use a 1:1.5 reward/risk ratio (risking
1.5 points to make 1 point) for gap
trades that are less than 40 mini Dow
points or 4 E-mini S&P points. For gaps
larger than these, use a 1:1 reward/risk
ratio. In the case of Figure 1, we would
risk 47 points to make 47 points. If the

gap had been 30 points, we would risk
45 points.
Some traders might question an
approach that risks more than the
potential profit. Most beginning traders
are taught to use a 3:1 reward/risk
ratio, risking 1 point to gain 3. They
inevitably wonder why they are repeatedly stopped out just before the market
turns. In general, wider stops produce
more winning trades; the key is to trade
only those setups with a better than 80percent chance of winning.
The market sold off immediately
after the bell, filling the opening gap
within an hour. Ironically, the next day
IBM came out with a disappointing
earnings report, knocking the market
down on the open. Figure 2 shows the
resulting buy setup had just a small
open loss at one point, although many
traders might have been stopped out
on the pullback around 11 a.m. ET.
However, keep in mind the strategy
is to maintain a reward/risk ratio of
1:1, not to tighten your stop when
the market moves in your favor. If
the stop had been hit, the loss would
have been approximately $305 per
contract ($2,745 for the nine-contract
full position), not including slippage
and commissions. This loss is reasonable because of the 80-percent

success rate of the setup.
Using a tighter initial stop or trailing stop would have turned this
position into a losing trade or, at
best, a breakeven trade. Using the
risk parameters designed for this
trade setup allowed the position to
remain open until the gap was filled
for a gain of 61 points. As a rule,
using a trailing stop will negatively
affect the gap trade’s win/loss ratio.
When the trade is executed, the
best thing a trader can do is to walk
away and let the orders do their
work. This is the difference between
professionals
and
amateurs:
Professionals won’t second-guess a

www.activetradermag.com • December 2004 • ACTIVE TRADER


trading methodology, while amateurs are constantly adjusting.

Ignore the reasons for the gap
The size or cause of a gap has little
impact on whether or not it will be
filled. Figure 3 shows an example
of emotions triggering an opening
price gap when, on Aug. 2, the

market gapped down on the open
because the U.S. government
issued a terror warning the previous day. There were rumors of a
plan to blow up a large financial
institution.
However, after a choppy first
half of the day, the market firmed,
shorts got nervous and started covering, and the gap was filled by
1:30 p.m. ET for a 6.75-point S&P Emini profit ($337.50 per contract).

FIGURE 4 MULTIPLE GAPS
The first opening gap on this chart — which remained unfilled for the next six days —
set up a short trade that was stopped out for a loss. Subsequent opening gap trades
were more successful.
Mini Dow September futures (YMU04), 15 minute
Gap of +62 points
fills in 6 bars

Gap of -52 points
fills in 9 bars

Short break of bear
flag. Target is gap
from 8/18

Gap of +13 points
fills in 1 bar

9,500
9,480

9,460
9,440
9,420
9,400
9,380

Gap of +44 points fills in 9 bars

9,360
9,340
9,320

Relax and trade

9,300
Figure 4 shows a 15-minute chart of
Gap
on
8/18
of
+44
points
the September mini Dow futures
fills on 8/25
9,280
(YMU04) with an opening gap on
Aug. 18 that did not get filled for
8/18
13:15 8/19 11:45 14:15 8/20 12:45
8/21

13:45 8/22 12:15
8/25
13:15 8/26
six trading days. (Other opening
gaps occurred before price eventuSource: TradeStation
ally filled the first gap.) On this day,
the mini Dow gapped up a modest
profit ($2,295). All these gaps followed each type of trade setup.
44 points prior to the release of some light pre-market volume, so they were
Gaps are the one moment of the tradeconomic numbers. The pre-market volexecuted with full positions.
ing day where everyone has to show
ume was modest, between 30,000 and
On Aug. 22, 2003, Intel announced their poker hand, and this creates a big
70,000 shares for the key stocks, so the
“cautious upside earnings revisions.”
advantage for short-term traders.
appropriate step was to short a two- The market exploded to the upside and
Understanding the dynamics behind
thirds-size position on the open.
gapped right above key resistance. The
opening gaps is paramount to trading
The market rallied, sold off a little just trade was to short the 62-point gap with them successfully.Ý
prior to the economic numbers, and then a full-size position. Six bars later, the tarshot higher once the numbers were
get was hit for a 62-point profit, or $310 For information on the author see p. 10.
released. Using the 1:1 reward/risk ratio per contract ($2,790).
resulted in a 44-point stop. The market
During the afternoon session, the marRelated Active Trader
never retraced to the gap’s midpoint ket traced out a bear flag pattern. With
level (where half the position could be the opening gap under the market still
articles

covered), and instead rallied right
unfilled, the trade was to place a sell stop
“Trading the overnight gap” by David
through the stop, producing a loss of at 9,392 to let the trend of the market iniNassar, March 2001, p. 66
$220 per contract. For a two-thirds positiate the trade based on a breakdown of
“Morning reversal strategy” by Bryan
tion (six contracts) the loss was $1,320.
the flag. The entry stop was filled and the
C. Babcook and Arthur Agnelli,
This move left an open gap below the risk point for the trade was above intraMay 2003, p. 36
market. The next day the market opened day resistance at 9,455. The target was the
modestly lower, triggering a long trade Aug. 18 gap at 9,304. The market spent
“Technical Tool Insight: Gaps,” April
that resulted in a quick $65-per-contract the rest of the day trending lower, filling
2003, p. 82
profit ($585 total). The following day the
the gap and resulting in an 88-point gain,
“Technical Tool Insight: Islands,”
market opened 52 points lower and or $440 per contract ($3,960).
August 2002, p. 82
filled the gap a few hours later for a
$260-per-contract profit ($2,340). The
A brief window of opportunity
You can purchase past articles online
next day, the market gapped up 44 The market’s nature is to prevent as
at www.activetradermag.com/
points, triggering a short trade that came many people as possible from consispurchase_articles.htm and download
close to the stop-loss point, but eventual- tently making money, which is why it is
them to your computer.
ly filled the gap for a $255-per-contract

crucial for a trader to follow rules for
ACTIVE TRADER • December 2004 • www.activetradermag.com

15


FIGURE 1 EQUITY CURVE
The frequency of down gaps increased after the broad market topped out in early
2000. The system exposure (light green area) increased substantially after this
point. Note that many of these gaps are still open.

Gap closer

130,000
120,000

Markets: Any.

110,000
100,000

System concept: Most traders are familiar
90,000
with the technical analysis axiom, “All gaps
are eventually closed.” A gap occurs when a
80,000
price bar’s high is lower than the previous low
70,000
or its low is higher than the previous high. A
60,000

significant gap creates a void in which no
trades occur, as shown in Figure 1. An “open50,000
ing gap” occurs when price opens above the
40,000
previous high or below the previous low; such
3
0,000
gaps can be filled the same bar, in which case
no visible bar-to-bar gap (such as the one in
20,000
Figure 1) will appear on the chart.
10,000
The idea that gaps are eventually closed
stems from the absence of trades within the
0
3/3/93
range of the gap. Because there are no traders
who are holding positions within the gap zone
(some may have entered positions earlier in
the chart’s history), there is an absence of the
upside resistance that is typically caused by traders seeking to
exit at breakeven or a profit-target level. Because of this lack of

1/7/94

1/3/95

1/2/96
Equity


1/2/97

1/4/99
Cash

1/3/00

1/2/01

1/2/02

1/2/03

Linear reg

resistance, price often moves sharply to close the gap when it
first recovers and penetrates the gap zone. This type of price
movement can also lead to the “island
FIGURE 2 SAMPLE TRADES
reversal” pattern, which occurs when a
gap in one direction is followed by (after
The system went long when Apple Computer gapped down more than 13 percent on
one or more intervening bars) a gap in the
June 19, 2002. Price started moving in the direction of closing the gap, but another
opposite
direction.
down gap occurred on July 17, 2002, causing a new long position to be established.
This test is designed to see if the axiom
Apple Computer (AAPL), daily
regarding closing gaps holds water. The

25.00
10 gaps, seven closed (70%)
system tested here goes long the day after
a large gap down and holds the position
24.00
until price reaches the low of the bar
23.00
immediately before the gap — i.e., when
the gap is closed.
22.00
This “system” is for experimental pur21.00
poses only. The goal is to test the effectiveness of trading gaps in the simplest way
20.00
possible; no protective stops are included.
19.00
Because of this, positions can be held
indefinitely and result in substantial draw18.00
downs when gaps are never closed. If you
wanted to actually trade a gap-based sys17.00
tem, you would most likely use a protec16.00
tive stop to protect against these losses.
Buy
15.00
14.00
Buy

Volume

20M


July 2002
Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)

16

August 2002

September 2002

Rules:
1. Enter long on the open the day after a
down gap greater than the 20-bar average true range (ATR) is completed.
2. Place a limit order to sell the position at
the low price of the bar that immediately preceded the gap.
3. The system will maintain multiple

www.activetradermag.com • May 2003 • ACTIVE TRADER


FIGURE 3 DRAWDOWN CURVE
open long positions (see Figure 2).
4. Hold the position indefinitely until the gap is
closed and the limit sell is triggered.
Money management: Risk 9 percent of account
equity per trade. This level was chosen because
it was the largest position size that allowed all
gaps to be traded during our test period.
Starting equity: $100,000 ($10 slippage/commission deducted per trade).

0%

-2%
-4%
-6%
-8%
-10%
-12%
-14%
-16%
-18%
-20%
-22%
-24%

As more gaps were opened and more long positions established,
a large drawdown began in 2000.

Test data: The system was tested on the Active
Trader Standard Stock Portfolio, which contains
3/3/93
1/28/94
the following 18 stocks: Apple Computer
(AAPL), Boeing (BA), Citibank (C), Caterpillar
(CAT), Cisco (CSCO), Disney (DIS), General Motors (GM),
Hewlett Packard (HPQ), International Business Machines
(IBM), Intel (INTC), International Paper (IP), JPMorgan Chase
(JPM), Coke (KO), Microsoft (MSFT), Sears (S), Starbucks
(SBUX), AT&T (T) and Wal-Mart (WMT).
Test period: January 1993 through January 2003.
System results: A total of 62 gaps occurred during the 10-year
test period. Of these, 50 (80 percent) were closed for a profit.

The remaining 12 gaps were open at the end of the test period.
The average profit for the closed gaps (which took, on averSTRATEGY SUMMARY
Profitability
Net profit ($):
Net profit (%):
Exposure (%):
Profit factor:
Payoff ratio:
Recovery factor:

11,942
11.94
28.42
1.27
0.34
0.35

Drawdown
Max. DD (%):
Longest flat days:

-24.75
465

2/1/95

1/30/96

2/3/97


1/4/99

1/3/00

1/2/01

1/2/02

1/2/03

age, 100 trading days to close) was just under 11 percent. By
comparison, the average loss of the 12 gaps that are still open
is a sharp -32 percent, and the average number of trading days
they have been open is about 350 (about one and a half years).
That most of the gaps in the test portfolio within the past 10
years have been closed reinforces the idea that gaps do have a
tendency to get filled — although it often takes a while.
However, the damage done by the minority of gaps that did
not close wiped out most of the profits achieved from the
majority of gaps that did close. This leads to the conclusion
that trading gaps on their own entails significant risk.
However, it is possible to combine gaps with other trading
tools and methods. The old saying, “All gaps are eventually
closed,” may not be totally accurate, but knowing the odds are
good that a certain price target will be reached can play an
important role in a trading strategy.Ý

Trade statistics
No. trades:
62

Win/loss (%):
80.65
Avg. gain/loss (%):
2.69
Avg. holding time:
148.15
Avg. profit (winners):
10.97
Avg. hold time (winners): 100.06

PERIODIC RETURNS

Avg. loss (losers) %:

-31.80

Weekly

0.03%

0.16

6.56% -12.50%

49.23%

9

17


Avg. hold time (losers):
Max. consec. win/loss:

348.50
38/4

Monthly

0.15%

0.16

13.54% -9.68%

47.90%

5

6

Quarterly 0.43%

0.15

16.34% -14.11%

53.66%

3


3

Annually

0.22

10.73% -12.90%

60.00%

4

1

LEGEND: Net profit — profit at end of test period, less commission •
Exposure — the area of the equity curve exposed to long or short positions, as
opposed to cash • Profit factor — gross profit divided by gross loss • Payoff
ratio — average profit of winning trades divided by average loss of losing
trades • Recovery factor — net profit divided by max. drawdown • Max DD
(%) — largest percentage decline in equity • Longest flat days — longest
period, in days, the system is between two equity highs • No. trades — num ber of trades generated by the system • Win/Loss (%) — the percentage of
trades that were profitable • Avg. profit — the average profit for all trades •
Avg. hold time — the average holding period for all trades • Avg. profit
(winners) — the average profit for winning trades • Avg. hold time (winners) — the average holding time for winning trades • Avg. loss (losers) —
the average loss for losing trades • Avg. hold time (losers) — the average
holding time for losing trades • Max. consec. win/loss — the maximum
number of consecutive winning and losing trades

— Compiled by Dion Kurczek of Wealth-Lab Inc.


Avg. Sharpe Best Worst
return ratio return return

1.60%

%
Max.
Max.
Profitable consec.
consec.
periods profitable unprofitable

LEGEND: Avg. return — the average percentage for the period • Sharpe ratio
— average return divided by standard deviation of returns (annualized) •
Best return — best return for the period • Worst return — worst return for
the period • % Profitable periods — the percentage of periods that were prof itable • Max. consec. profitable — the largest number of consecutive prof itable periods • Max. consec. unprofitable — the largest number of consec utive unprofitable periods
Trading System Lab strategies are tested on a portfolio basis (unless
otherwise noted) using Wealth-Lab Inc.’s testing platform.
If you have a system you’d like to see tested, please send the trading and money-management rules to

Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or
promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not
guarantee future results; historical testing may not reflect a system’s behavior in real-time trading.

ACTIVE TRADER • May 2003 • www.activetradermag.com

17


FUTURES


Trading System Lab
FIGURE 1 PORTFOLIO EQUITY CURVE

Gap closer

The equity curve exhibits some volatility, but also an overall upward
bias and extremely low market exposure. This is a result of the small
number of trades, as well as their short holding periods.

Markets: Any.

System concept: The stock Trading System Lab (p. 54) featured an experimental system designed to trade gaps. The
intention was to go long on every down gap and hold the
position until the gap was closed (if it ever closed). This provides useful information about the dynamics of gap behavior.
However, it is not possible to hold a losing futures position in a similar manner because the higher leverage in
futures results in losses of a much larger magnitude. Taking
this into account, the futures system goes long right when
price is starting to fill a down gap. The absence of resistance
in the price void of the gap should provide positive momentum for a long trade. Based on the results of the stock test, it
is likely most of the gaps will be filled.
In addition, this system uses three different exits to protect capital while giving trades room to breathe. The strategy uses a breakeven stop entered soon after the trade is profitable to protect against a reversal. When the gap is not filled
and prices do not reach our breakeven level, we employ a
wide stop-loss order.
The system should have a large number of winning and
breakeven trades, and a small number of large losses.
Because of the high expected win-loss ratio, the strategy uses an
aggressive maximum risk setting (10 percent equity loss per
FIGURE 2 SAMPLE TRADES


200,000
190,000
180,000
170,000
160,000
150,000
140,000
130,000
120,000
110,000
100,000
90,000
80,000
70,000
60,000
50,000
40,000
30,000
20,000
10,000
0

8/16/93

7/4/94

6/2/95

Equity


370.00

360.00

350.00

340.00

330.00

320.00

310.00

300.00

290.00

Volume
100,000

May 1999

June 1999

July 1999

Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)

18


August 1999

September 1999

4/1/97

3/2/98

Cash

1/3/00

1/2/01

1/2/02

Linear reg

trade). All traders must weigh these considerations and determine their personal risk tolerance when deciding on the stoploss and maximum risk levels.

Gaps in gold trigger two trades. The green lines represent the entry points and the red lines
represent the profit-target exits. Notice how prices gapped up to close the first gap down,
forming an island reversal. The second gap also closed, but not before the trade was
stopped out. Increasing the stop-loss distance would have turned this trade into a winner.
Gold futures (GC), daily

5/1/96

October 1999


Rules:
1. A long entry setup occurs when there is
a down gap greater than the 20-bar average true range (ATR). Multiple open
trades are acceptable.
2. Go long on a buy stop order at the high
of the down-gap bar plus one tick.
3. Exit with a profit using a limit order at
the low of the bar that preceded the
down gap.
4. Place a stop-loss order below the entry
price that is three times the distance
between the entry price and the profit
target level.
Note: Wait until the close of the entry bar
before placing the profit target and stoploss orders.
5. As soon as the contract closes with a gain
of at least one percent, place a breakeven
stop to exit at the entry price.
Risk control and money management:
1. Starting equity: $100,000. Deduct $10
slippage/commission per contract
(entry and exit).
2. The number of contracts to buy is determined by calculating the distance
between the entry price and the initial
stop-loss level. Buy the number of
contracts that results in a maximum loss
of 10 percent if the stop-loss is hit.

www.activetradermag.com • May 2003 • ACTIVE TRADER



FIGURE 3 DRAWDOWN CURVE
Test data: The system was tested on the Active Trader
Standard Futures Portfolio, which contains the following 20 futures: DAX30 (AX), corn (C), crude oil (CL),
German bund (DT), Eurodollar (ED), Euro Forex (FX),
gold (GC), copper (HG), Japanese yen (JY), coffee (KC),
live cattle (LC), lean hogs (LH), Nasdaq 100 (ND), natural gas (NG), soybeans (S), sugar (SB), silver (SI), S&P
500 (SP) and10 year T-Notes (TY).
Test period: This test used ratio-adjusted data (from
Pinnacle Data Corp.) spanning August 1993 to
November 2002.

0.00%
-2.00%
-4.00%
-6.00%
-8.00%
-10.00%
-12.00%
-14.00%
-16.00%
-18.00%
-20.00%
-22.00%
-24.00%

Test results: There were a total of 69 trades during the
test period. This was less than the number of gaps that
occurred, but because the system enters as price begins

to penetrate the gap, there could be setups that have not triggered trades yet. Eleven of the trades triggered our breakeven
stop and were closed at the breakeven level. Ten trades were
losers, while 48 were winners. This confirms our expectation of
the system’s win-loss behavior.
Counting breakeven trades as losers, the system had a winloss ratio of nearly 70 percent. The average profit of winning

8/16/93

STRATEGY SUMMARY
Profitability

Trade statistics

Net profit ($):

94,659

Net profit (%):

94.66

Exposure (%):

3.07

No. trades:
Win/loss (%):

69
69.57


Avg. gain/loss (%):

0.96
16.62

Profit factor:

1.79

Avg. holding time:

Payoff ratio:

0.96

Avg. gain (winners) %:

2.54

Recovery factor:

2.08

Avg. hold time (winners):

8.96

Avg. loss (losers) %:


Drawdown
Max. DD (%):
Longest flat days:

-2.65%

-25.27

Avg. hold time (losers):

34.14

570

Max. consec. win/loss:

7/3

The largest drawdown, which began in late 1999, was eliminated in
mid-2002. The system exhibits a favorable recovery factor (the net
profit divided by the maximum drawdown) of 2.08.

LEGEND: Net profit — profit at end of test period, less commission •
Exposure — the area of the equity curve exposed to long or short positions, as
opposed to cash • Profit factor — gross profit divided by gross loss • Payoff
ratio — average profit of winning trades divided by average loss of losing
trades • Recovery factor — net profit divided by max. drawdown • Max DD
(%) — largest percentage decline in equity • Longest flat days — longest
period, in days, the system is between two equity highs • No. trades — num ber of trades generated by the system • Win/Loss (%) — the percentage of
trades that were profitable • Avg. gain — the average profit for all trades •

Avg. hold time — the average holding period for all trades • Avg. gain
(winners) — the average profit for winning trades • Avg. hold time (winners) — the average holding time for winning trades • Avg. loss (losers) —
the average loss for losing trades • Avg. hold time (losers) — the average
holding time for losing trades • Max. consec. win/loss — the maximum
number of consecutive winning and losing trades

7/5/94

6/6/95

5/3/96

4/4/97

3/5/98

1/3/00

1/2/01

1/2/02

trades was 2.54 percent, while the average loss of losing trades
was -2.65 percent. Overall, these are very positive statistics,
considering the degree to which the win-loss ratio is leaning
toward the win column.
The similar behavior of gaps in stocks and futures is interesting. By analyzing the behavior of gaps in one market we
were able to design a profitable system based on the same phenomenon in a different market.
The message of this strategy is that it is worthwhile to pay
attention to gaps, especially when prices start to fill a gap. The

lack of resistance in the gap area can be exploited if you can act
quickly enough.
— Compiled by Dion Kurczek and Volker Knapp of Wealth-Lab Inc.

PERIODIC RETURNS
Avg. Sharpe Best Worst
return ratio return return

%
Max.
Max.
Profitable consec.
consec.
periods profitable unprofitable

Weekly

0.16%

0.50

15.91% -12.98%

24.28%

4

55

Monthly


0.70%

0.52

19.31% -12.98%

36.28%

4

13

Quarterly 2.05%

0.52

32.62% -12.16%

52.63%

4

4

Annually 10.21% 0.55

39.42% -12.75%

77.78%


6

2

LEGEND: Avg. return — the average percentage for the period • Sharpe
ratio — average return divided by standard deviation of returns (annualized)
• Best return — best return for the period • Worst return — worst return
for the period • % Profitable periods — the percentage of periods that were
profitable • Max. consec. profitable — the largest number of consecutive
profitable periods • Max. consec. unprofitable — the largest number of
consecutive unprofitable periods
Trading System Lab strategies are tested on a portfolio basis (unless
otherwise noted) using Wealth-Lab Inc.’s testing platform.
If you have a system you’d like to see tested, please send the trading and money-management rules to

Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or
promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not
guarantee future results; historical testing may not reflect a system’s behavior in real-time trading.

ACTIVE TRADER • May 2003 • www.activetradermag.com

19


STOCK INDEX FUTURES TRADING COLLECTION
“Using the TICK to identify the intraday trend”
by David Bean (Active Trader, May 2006).

“Counterpunch stock index futures system"


by Active Trader Staff (Active Trader, Nov. 2002)
“Extreme open-close days”

by Xavier Maria Raj (Active Trader, April 2005).
“The Fibonacci Swing Filter”

by Gomu Vetrivel (Active Trader, Feb. 2005).
“Trading the opening gap”

by John Carter (Active Trader, Dec. 2004).
“Hitting the street: The S&P 500 futures' intraday reactions to economic reports”
by David Bukey (Active Trader, May 2005).

“Sector vs. index: The single stock futures-Dow spread”
by Keith Schap (Active Trader, Nov. 2005).

“Trading the basis: How stock index arbitrage impacts the market”
by David Lerman (Active Trader, March 2003).
“Stock index spreads: S&P vs. Naz”

by Keith Schap (Active Trader, May 2006).
“The multibar range breakout system”

by Dennis Meyers, PH.D. (Active Trader, Jan. 2004).
“Following through in the S&Ps”

by Thom Hartle (Active Trader, Dec. 2003).
“Getting in on follow-through days”


by Thom Hartle (Active Trader, Jan. 2004).
“Follow-through in the E-Mini Nasdaq 100”
by Thom Hartle (Active Trader, Aug. 2004).

“Up-down volume and next-day follow-through”
by Thom Hartle (Active Trader, Dec. 2004).

“E-Mini morning reversal and afternoon breakout patterns”
by Gomu Vetrivel (Active Trader, Jan. 2006).
“The telltale spread”

by Thom Hartle (Active Trader, Nov. 2003).

2
7
9

13
17
21
27
31
35
39
44
49
54
60
66
70



TRADING Strategies

Using the TICK

TO IDENTIFY THE INTRADAY TREND
Analyzing TICK readings over the past five years provides
the foundation for an intraday trend strategy.

BY DAVID BEAN

T

he TICK indicator measures
intraday momentum in
New York Stock Exchange
(NYSE) stocks by tracking
the difference between upticking stocks
(last price higher than previous price)
and downticking stocks (last price lower

than previous price). The TICK subtracts
the number of downticking stocks from
the number of upticking ones to generate a momentum snapshot of the market
at any given time.
For example, if at 10 a.m. 2,000 stocks
were trading higher than their previous

FIGURE 1 FIVE-YEAR AVERAGE NYSE VOLUME (15-MINUTE INTERVALS)

The second-largest NYSE volume occurred in the first 15 minutes of trading,
which is a good time to determine the daily trend because price moves are
more meaningful when backed by large volume.

prices while 1,500 stocks were trading
lower than their previous prices, the
TICK value would be +500 (2,000-1,500).
Traders typically use the TICK indicator
to gauge the level of buying or selling
pressure throughout the day. If the TICK
reading is high, the market is showing
“internal” strength, which is different
from the “outward” price movement.
According to popular interpretation,
TICK levels that correspond with price
action help confirm the market’s direction, but TICK values that diverge from
price can warn of possible reversals. For
example, a typical bullish signal occurs
when the S&P 500 is climbing when the
TICK is positive (or trending higher).
However, if the S&P 500 is rising but the
TICK turns negative (or trends lower),
the rally could be nearing its end. (For
more information on the TICK, see
“TICK basics.”)

From analysis to trading

This kind of analysis depends on logically defining “high” or “low” TICK readings. The following study analyzed
intraday TICK behavior in the past five

years to find potentially bullish and
bearish TICK levels. However, the
resulting trade strategy also relied on
NYSE volume analysis and price action
to confirm the intraday trend and gener2

www.activetradermag.com • May 2006 • ACTIVE TRADER


TABLE 1 FIVE-YEAR TICK STATS

ate trade signals.
The focus was on the first 15 minutes
of the daily trade session because over
the past five years the NYSE’s secondlargest volume has occurred during this
period. Above-average TICK readings
generate buy signals at 9:45 a.m. ET. By
contrast, sell signals require below-average TICK readings along with downward price moves (gaps or weakness)
within the first 15 minutes.
The logic of this approach is that highvolume periods combined with price
moves and TICK readings in the same
direction help determine the trend for
the rest of the day.

Trend clues at market’s open

Figure 1 shows the NYSE’s average volume of more than 3,700 stocks in 15minute intervals from 9:30 a.m. to 4 p.m.
ET over the past five years. While volume is highest in the last 15 minutes of
trading, the second-highest volume
occurred in the first 15 minutes of the

regular session — from 9:30 a.m. to 9:45
a.m.
The day’s open and close stand out
because institutional traders must execute large amounts of market-on-open
and market-on-close orders; the price
moves that occur during these periods
can leave clues about the market’s likely
direction. Although you can trade stocks
and stock-index futures in the afterhours electronic market, those markets
offer very little volume to offset positions against overnight breaking news
while the U.S. stock market is closed for
17.5 hours.

Defining TICK thresholds

Table 1 shows statistics behind the TICK
indicator’s historical behavior over the
past five years. Overall, the TICK had a
bullish bias. The average daily TICK
high was nearly twice as large as the
daily low (+1,007 vs. -673). Also, the
TICK’s average close after 15 minutes
was not only above zero (+201) but
exceeded +300 almost six times as often
as it fell below -300. Buy and sell signals

must take this upside bias into account.
The strategy’s bullish and bearish
thresholds are based on the TICK’s average close of +201 after 15 minutes. There
are thresholds for both high and low

readings as well as for where the TICK
closes. The high and low thresholds are
+750 and -350, which are approximately
+/-550 from the average close of +201;
the closing TICK thresholds are +500
and -100, which are approximately
+/- 300 from the average close of +201.
This means the TICK is bullish if it
either reaches +750 within the first 15
minutes of trading or closes above +500
at 9:45 a.m. Similarly, the TICK is bearish
if it drops below -350 within the first 15

The TICK has had a bullish bias
over the past five years. Its average daily high is nearly double its
daily low, its average close every
15 minutes was +201, and it
exceeded +300 nearly six times as
often as it dropped below -300
(based on 15-minute intervals).
TICK value

Five-year high:

+1,541

Avg. daily high:

+1,007


Five-year low:

Avg. daily low:

Avg. closing value
after 15 minutes:

No. of 15-minute
closes above +300:
No. of 15-minute
closes below -300:

-1,495
-673

+201
12,855
2,262

T

TICK basics
he TICK is a very short-term (intraday) indicator that measures the
bullish (upticking) or bearish (downticking) activity in NYSE stocks
throughout the day. TIKI is the symbol for the same indicator calculated on Dow Jones Industrial Average stocks; some data services also
supply the TICK calculated on Nasdaq stocks.
The TICK is a breadth indicator that gives traders an intraday look at the “internal” strength or weakness of the market — that is, the strength or weakness
beyond whether the overall market is up on a point or percentage basis. By comparing the number of stocks advancing to stocks declining, the indicator reflects
the market’s up or down momentum at a given moment.
For example, if the S&P 500 index is up marginally but downticking stocks are

consistently outnumbering upticking stocks (and the number of downticking
stocks is increasing, reflected by a downtrending TICK indicator), it is likely that
only a relative handful of strong stocks are propping up the overall market.
When buying completes in these stocks, a down move may result.
Two contrarian uses of the TICK indicator are to look for divergence between
price and the indicator, and to use high or low TICK readings to identify momentum extremes (similar to how many traders use oscillators like the relative
strength index or stochastics to locate overbought and oversold points).
A divergence occurs when price makes a new high (or low) but the TICK
makes a lower high (or higher low), failing to confirm the price move and warning of a slackening of momentum and potential stall or reversal. A similar phenomenon would be a steady trend in the TICK that runs counter to the trend of
the market. Extreme high or low TICK readings sometimes accompany market
climaxes.
Because the TICK is a snapshot of the market at a given moment (and is thus
very volatile), it can be deceptive. Because of this, the TICK is commonly
smoothed with a 10-period moving average to remove some of the “noise” and
better reveal the indicator’s direction and patterns.

ACTIVE TRADER • May 2006 • www.activetradermag.com

3


Strategy code
Tradestation EasyLanguage Code
{Data1 is @ES.D or any of the following: @ER2.D, @YM.D, @NQ.D, @EMD.D
Data2 is $TICK. Both Data1 and Data2 are 15 minute charts – a custom session should be built for @YM.D to trade between 8:30 am CST and 3:15 pm CST
instead of starting at 7:20 am CST.
*there are 27, 15 minute bars in the trading day}
Inputs: R(5), L1(27);
If Time=945 and H of data2 > 750 and L of data2 > -350 Then Buy Next Bar at
market;

If Time=945 and C of data2 > 500 and L of data2 > -350 Then Buy Next Bar at
market;
If Time=945 and Open > LowD(1) - 2*Average(Range,27) and L of data2 < -350
and H of data2 < 750 Then Sell Short Next Bar at OpenD(0) Limit;
If Time=945 and Open > LowD(1) - 2*Average(Range,27) and C of data2 < -100
and H of data2 < 750 Then Sell Short Next Bar at OpenD(0) Limit;
If Time=945 and C > C[1] and L of data2 < -350 and H of data2 < 750 Then Sell
Short Next Bar at CloseD(1) Stop;
If Time=945 and C > C[1] and C of data2 < -100 and H of data2 < 750 Then
Sell Short Next Bar at CloseD(1) Stop;
If Time=945 and C>(O + Average(Range,27)) and L of data2 > -350 Then Buy
Next Bar at market;
If Time=945 and C<(O - Average(Range,27)) and H of data2 < 750 Then Sell
Short Next Bar at market;
SetStopLoss(R*BigPointValue*Average(Range,L1));
SetExitonClose;
Strategy code can be copied at www.activetradermag.com/code.htm.
minutes or closes below -100 at 9:45 a.m.

TICK’s low > -350, buy at the
market.

There are three long-entry and five
short-entry rules. Although each rule is
independent, meaning it could be tested
individually, all eight rules are combined
to make a single system designed to
trade the S&P 500 E-Mini futures (ES).
The rules were also tested on the Russell
2000 E-Mini (ER2), Midcap 400 E-Mini

(EMD), Mini Dow (YM), and Nasdaq
100 E-Mini (NQ).

3. If the close of the first 15-minute
bar > the open + the average range
(high - low) of all 27 of yesterday’s
15-minute bars, and the TICK’s
low > -350, buy at the market.

Trade rules

Long entries (at 9:45 a.m. ET):
1. If the TICK’s high > +750 and the
TICK’s low > -350, buy at the
market.
2. If the TICK’s close > +500 and the
4

Short entries (at 9:45 a.m. ET):
1. If today’s open > yesterday’s low (2 * the average range of all 27 of
yesterday’s 15-minute bars), the
TICK’s low < -350, and the TICK’s
high < +750, sell short for the next
15 minutes (until 10 a.m.) at
today’s open (limit).
2. If today’s open > yesterday’s low (2 * the average range of all 27 of

yesterday’s 15-minute bars), the
TICK’s close < -100, and TICK’s
high < +750, sell short for the next

15 minutes (until 10 a.m.) at
today’s open (limit).
3. If the close of the first 15-minute
bar > the previous day’s close, the
TICK’s low < -350, and the TICK’s
high < +750, sell short for the next
15 minutes (until 10 a.m.) at
yesterday’s close (stop).
4. If the close of the first 15-minute
bar > the previous day’s close, the
TICK’s close < -100, and the TICK’s
high < +750, sell short the next 15
minutes (until 10 a.m.) at
yesterday’s close (stop).
5. If the close of the first 15-minute
bar < the open - the average range
of all 27 of yesterday’s 15-minute
bars and the TICK’s high < 750,
then sell short at the market.
Exit:
1. Stop-loss = R * contract’s point
value * average range of all 27
previous 15-minute bars since the
same time yesterday. (R = multiplier
that can be optimized for each
market or risk preference; default
= 5.)
2. Exit on close if still in market.

Trade logic


All eight signals are based on TICK
behavior and price direction within the
first 15 minutes of trading. Two of the
three long rules focus solely on exceeding TICK’s bullish thresholds and staying above its bearish ones. Also, four of
the five short rules require TICK to penetrate the bearish levels as it stays below
the bullish ones.
The other two rules don’t wait for
either TICK threshold to be met. To trigger a buy signal, price must climb further than the average range of all of yesterday’s 15-minute bars (long rule 3), or
price must drop the same distance
before selling short (short rule 5).

www.activetradermag.com • May 2006 • ACTIVE TRADER


below yesterday’s close, the strategy
sells short with a limit order at today’s
open in the second 15 minutes. That gap,
however, must be smaller than twice the
average range of yesterday’s 15-minute
bars.
The stop-loss depends
on the average range of
FIGURE 2 TRADE EXAMPLE
yesterday’s 15-minute bars,
the contract’s point value,
The S&P 500 E-Mini fell slightly on Feb. 2, and the TICK low (-383) was bearish by 9:45
and a multiplier (R) to
a.m. because it dropped below the lower threshold (-350). The system sold short at
adjust the stop size. If that

1,284, and the S&P E-Mini sold off throughout the day — a gain of 12.75 points.
stop-loss isn’t hit, the system holds the trade until
the end of the day to let
profits run.

However, these rules still require the
TICK to remain above its average low
(-350) or below its average high (+750),
respectively.
The first four short rules must be executed using stop or limit orders. For

example, if price climbs above yesterday’s close by 9:45 a.m., it must drop
back to that point before the system sells
short with a stop order in the second 15
minutes of the trading session (until 10
a.m.). Also, if the opening price gaps

Trade example

Figure 2 shows a 15-minute
chart of the March 2006
S&P 500 E-Mini futures
(ESH06) on Feb. 2. The
market dropped slightly at
the open, and the TICK
readings at 9:45 a.m. were
low (-383), high (+125), and
close (+99). The S&P 500
had a short bias because the
TICK’s low was below the

bearish threshold of -350
and its high was below the
bullish level of +750.
The system placed a
limit order at 9:45 a.m. at
the E-Mini’s opening price
(1,284.00), and the S&P 500

Source: Tradestation 8.1

TABLE 2 OVERALL TEST RESULTS

The strategy was profitable across the major indices in different time periods. All markets had a favorable percentage of gains,
and all but one had average profits per trade of at least $54.72. However, the Nasdaq 100 didn’t perform as well.
Start
date
E-Mini S&P 500

9/11/97

E-Mini Russell 2000 11/7/01
E-Mini Midcap 400 1/28/02
E-Mini Nasdaq 100

Mini Dow

5

7/1/99


7/28/02

No. of
trades

Profit

1,128 $67,237.50
726
709

$42,990.00
$38,800.00

1,006 $14,160.00
579

$37,910.00

Drawdown Percentage Avg.
profitable profit per
trade

$10,637.50

53.90%

$59.61

$4,760.00


52.47%

$54.72

$6,280.00

$23,760.00
$3,520.00

52.75%

51.29%

56.82%

$59.21

$14.08

$65.47

Profit
Avg.
factor winning
trade
1.33

-$393.90


1.31

-$400.74

$401.53

-$338.13

$454.73

1.05

$529.22

1.60

Ratio
avg. win/
avg. loss

$444.10

1.33
1.35

Avg.
losing
trade

$307.39


-$549.72

-$259.10

1.11

1.19

0.96

1.19

www.activetradermag.com • May 2006 • ACTIVE TRADER


TABLE 3 TEST RESULTS: JAN. 1, 2003 TO FEB. 1, 2006

Performance suffered slightly in this second test because the markets’ daily ranges narrowed in the past three years.
However, most markets remained profitable even if you consider slippage and commission costs (not included).
Profit

No. of
trades

Drawdown

E-Mini S&P 500

$20,112.50


477

$3,012.50

E-Mini Midcap 400

$23,360.00

553

$4,760.00

E-Mini Russell 2000
E-Mini Nasdaq 100
Mini Dow

$28,690.00
$7,670.00

$19,815.00

534

$6,280.00

511

$3,530.00


498

hit this price between 9:45 a.m. and 10
a.m., going short 0.25 points from the
day’s high. The market sold off throughout the day, and the system exited at the
close (1,271.25) for a 12.75-point gain.
The Russell 2000 E-Mini, Midcap 400
E-Mini, and mini Dow all took similar
trades as each of these markets climbed
back to the open and then dropped. No
trade was triggered in the Nasdaq 100 EMini because this market didn’t trade
back to the open.

$3,520.00

Percentage
Avg.
profitable profit per
trade
53.67%

$42.16

1.35

52.80%

$42.24

1.28


52.81%
51.86%

55.22%

$53.73
$15.01

$39.79

Test results

The TICK strategy was tested on historical intraday price data going back at
least three years in the S&P 500 E-Mini
futures, Russell 2000 E-Mini, Midcap 400
E-Mini, Mini Dow, and Nasdaq 100 EMini. Table 2 (p. 5) shows results for
each index in different time periods from
Sept. 11, 1997 to Feb. 1, 2006.
For comparison purposes, each index
was also tested over the same time period — Jan. 1, 2003 to Feb. 1, 2006 (Table

Related reading
“The Crown pattern”
Active Trader, January 2004.
Here’s a way to use some specific calculations to improve the odds of trading
a variation of a classic chart pattern — on an intraday basis.
“Intraday trading with the TICK”
Active Trader, April 2002.
Find out how the TICK indicator can complement other trading tools in identify low-risk trades. Here’s how one trader combines the TICK with support and

resistance analysis and retracement levels.
“Indicator insight: TICK/TIKI”
Active Trader, March 2001.
How to calculate and interpret the TICK, a popular short-term indicator that
measures intraday buying and selling pressure.
You can purchase and download past articles at
www.activetradermag.com/purchase_articles.htm.

6

Profit
factor

1.30
1.14

1.38

Avg.
winning
trade

Avg.
losing
trade

Ratio
avg. win/
avg. loss


-$392.36

1.13

$304.35

-$270.09

$363.97

-$325.18

$444.01
$231.25

$262.56

-$228.13

-$241.43

1.13
1.12

1.01

1.09

3). Comparing Tables 2 and 3 shows that
although the average profit per trade

dropped in recent years, the average
trade is still large enough (at least
$39.79) to make money after slippage
and commission costs. (The Nasdaq 100
E-Mini’s average profit of $15.21 was
the exception to this rule.) Average profits fell because the markets’ daily ranges
have decreased in recent years.
The system trades often — roughly
three times a week in each market over
the past three years, or 500 trades in 750
trading days.
Overall, the system caught roughly
10 percent of the S&P 500’s 50-day average daily trend. For example, if the S&P
E-Mini has a 10-point daily range, and
the system captures 10 percent of it,
then its average profit is one point
($50). This roughly matches the system’s average profit in the S&P 500 in
both time periods. (As of Feb. 1, the
S&P E-Mini’s 50-day average range was
9.84 points.)

Further research

One idea that deserves additional attention is to sell rallies short when the TICK
signals a downtrend, or buy dips after it
signals an uptrend at 9:45 a.m.
Instead of trading just one contract
after any of the eight rules signal a trade,
you could trade multiple contracts (e.g.,
one for each signal). However, you’d

have to limit short positions to three to
balance the size of long and short trades
in the market.

www.activetradermag.com • May 2006 • ACTIVE TRADER