Although futures contracts trade around the clock on electronic exchanges, normal stocks are typically only bought and sold during what is known as the “regular cash session”. This of course includes the component stocks underlying futures indexes such as the ES or YM. The cash session is the period of time in which the primary exchange on which those stocks are traded is open, and this is where large volumes of the stock will be traded. Nevertheless, stocks (and indeed most derivatives such as futures) can also be purchased electronically at pretty much any time of the day or night, and hence the price of a stock (or the index of which it is a part), will typically continue to move outside of the regular cash session.
This leads to the phenomenon of the opening gap. The gap in question is that between the closing price of yesterday’s cash session, and the opening of the cash session today. The gap is significant because on most days it will ‘fill’ at some point during the day’s trading (ie price will trade from today’s open back to yesterday’s close) – the overall historical probabilities for this on the YM (Dow Future) index are roughly 76%. Such high probabilities for raw price action are rare in trading, and where they exist they give us the natural edge that we need to start building a futures trading strategy – it becomes a question of applying a number of filters to further increase this probability to a level that will prove consistently profitable.
The reason why a price gap has occurred, incidentally, is fairly immaterial. Usually price drifts on low volume off the back of news flows throughout the night, testing notional support and resistance.
There are only two exceptions to the above. One is when price moves overnight because of significant new information – such moves are driven by large volumes, and will be filtered out by our parameters below. The other is what is known as ‘a professional gap’ where, by consensus, institutions effectively move prices pre-market to meet their own designs; such moves tend to be extreme, and will also be filtered out by our parameters.
Fading an Opening Price Gap Using the YM or ES Futures Contract
CLOSE
HIGH
LOW
Discretionary Parameters (some or all of these can be employed as filters).
This leads to the phenomenon of the opening gap. The gap in question is that between the closing price of yesterday’s cash session, and the opening of the cash session today. The gap is significant because on most days it will ‘fill’ at some point during the day’s trading (ie price will trade from today’s open back to yesterday’s close) – the overall historical probabilities for this on the YM (Dow Future) index are roughly 76%. Such high probabilities for raw price action are rare in trading, and where they exist they give us the natural edge that we need to start building a futures trading strategy – it becomes a question of applying a number of filters to further increase this probability to a level that will prove consistently profitable.
The reason why a price gap has occurred, incidentally, is fairly immaterial. Usually price drifts on low volume off the back of news flows throughout the night, testing notional support and resistance.
There are only two exceptions to the above. One is when price moves overnight because of significant new information – such moves are driven by large volumes, and will be filtered out by our parameters below. The other is what is known as ‘a professional gap’ where, by consensus, institutions effectively move prices pre-market to meet their own designs; such moves tend to be extreme, and will also be filtered out by our parameters.
Fading an Opening Price Gap Using the YM or ES Futures Contract
- Firstly, ascertain the following key values for the previous day’s regular cash session:
CLOSE
HIGH
LOW
- For the YM (Dow Future) index the regular cash session commences at 14:30 GMT, and closes at 21:00 GMT. After the close, there is a settlement auction, and it is the 21:15 closing price of this auction (known as the ‘uncrossing price’) that you require. This may be different to the closing price reported by news agencies etc – but it is the correct price for fading gaps.
- Look at where the futures price is trading just prior to the open to determine whether there will be a gap (ie will the current day’s OPEN differ from the prior day’s CLOSE?).
- Assuming there is an opening gap in the futures price, the next step is to decide whether or not to trade it. Do this using the criteria given below.
- Enter exactly upon the cash session open (some platforms provide a time-order function ideal for this, and a futures broker should accept an ‘on the open’ instruction), long or short in the direction of the prior day’s close. Do not queue your order – enter at the market. Your target should be the level of the prior day’s close, for a complete gap fill. Use a stop loss equal to the size of the gap, unless it is less than 40 points, in which case it should be one and a half times the gap size.
- If neither your stop nor your target has been hit by the end of the regular cash session, you should exit your position at the market.
- Critical Parameters (break these rules and probability is no longer on your side!)
- Following an up-day (CLOSE above OPEN), trade only gaps opening between the previous day’s OPEN and HIGH.
- Following a down-day (CLOSE below Open), trade only gaps opening between the previous day’s OPEN and LOW.
- Never trade gaps on the first trading day of the month, on options expiration day (the third Friday in the month) or the subsequent Monday, the day of the monthly jobs report (the first Friday of each month), or from 24th December to 2nd January inclusive.
- Do not trade gaps larger than 70 Dow points.
- Trade only gaps that are less than 40% of the prior day’s true range (HIGH minus LOW) in size.
- Do not trade gaps following an ‘outside day’ (days with a HIGH that is higher than the prior day and a LOW that is lower).
Discretionary Parameters (some or all of these can be employed as filters).
- Ignore gaps on Mondays.
- When price is trading above the 600EMA on a five minute chart (displaying 24 hour data), take only short positions, and take only long positions when it is trading below. Gap fading in the direction of the EMA (by which we do not mean in the direction that the EMA is ‘pointing’, but making a trading assumption that price will tend to move towards the EMA) has a higher win-rate and better profit factor. A linear regression line plotted on the current trend could be similarly employed.
- Do not fade gaps following Doji days (days that opened and closed at virtually the same price).
- Do not trade gaps whose opening lies within the range of all four prior candles.
- Take only gaps opening below the R2 and above the S2 daily pivot levels.
- Go long (fade down gaps) only on Mondays, Tuesdays, and Fridays. Go short (fade up gaps) only on Wednesdays and Thursdays. Historically these are the days when the Dow is most likely to rally or sell-off.