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Just a quick share for members and non-members alike, pointing out the possibilities of trading a gap down to its open.
This morning, the German DAX cash index opened with a gap of about 20 DAX points.
There was no commensurate overnight up-move in the S&P500 CFDs, which might indicate risk-on sentiment and a strong move up in advance.
From 7am London time, the market continues to advance away from the gap, with some technical signs of overheating.
First sell order
In the first order, a sell stop is placed to sell the market at 12467.2 just before 8am London time. The market continues to advance, so this order is not filled and is cancelled.
At precisely 8am London time, the latest 5 minute candle shows strong bullish candle, but which again shows technical overheating, and several of the other timeframes are also showing such overheating.
In this case, the overheating indicator confluence happens to be the Commodity Channel Index (CCI) set to 5 periods, and the overheating level is 167.
Second sell order
A sell stop is placed just below its high, at 12477.5, with a tight 4 point stop loss and a take profit of 12445.5. The stop loss is promptly hit, which is to be expected with such high reward trades.
In this case there was an additional 0.2 points of slippage, taking the loss accrued to 4.2 points – not exactly a bank breaker!
The idea here is to accept small losses, but to stay in for the big winning trades.
Third sell order
We will have one more try, the order being set to enter again, after the doji just below its open and just below the high of the overheating candle before that, an aggressive sell stop entry entry of 12378.35.
NB In the Quantisi Ltd. trade plan, which I will be making commercially available via this blog, a maximum of 3 units or 3 tries at any one given trade is the absolute maximum, and sticking rigorously to the risk management strategy is as always, essential.
Sell stop order filled
Figure 1, below, shows the trade having been placed. The entry is shown by the green dot-dashed line at 12478.35 (bid – filled), the stoploss is just 3.15 DAX points above that at 12481.5 (ask), allowing 2.15 pips of upward movement over and above the 1 pip of broker’s spread factored in.
This is an exaggerated tight stop, however, for the purposes of this trade it worked fine. The reason for the extreme tight stop is the desire to obtain a very good risk reward ratio, especially since the first trade did not work out and this is chance 2 out of a potential 3.
Figure 1. The DAX gap trade several minutes after being filled
Trade risk management parameters
The take profit is at 12455.9 (ask). Therefore 3.15 pips are risked (including broker’s spread) while a reward of 22.45 pips are sought. This includes 7 x 3.15 pips and an additional 0.4 pips to account for negative slippage on the trade.
This is actually a very conservative target, given that the gap trade normally seeks to fill the gap itself (see also figure 4). What we are actually targeting is the opening candle after the gap, so it seems a very reasonable target since many gaps seek to be filled. More on identifying specific types of gap and what to expect from them in stock index trading in another post.
The precise risk to reward ratio of the filled trade is 1:7.127, or rounded down, 1:7, more than satisfactory given the 1:2.5 minimum advocated in our trade plan rules.
Figure 2 shows the evolution of the trade, and indeed when the price has hit the take profit (buy limit) level, the order is filled, and in fact, we are granted the treat of positive slippage of a luxurious 2.2 points – another good reason to use our recommended brokerage.
Take profit (buy limit)
Figure 2. Take profit order filled.
Figure 3 shows the three main order sets mentioned, the first the trade that was not filled and cancelled, the second which resulted in a stop loss being hit, and the third successful 1:7 risk to reward trade, with the final risk reward being 1:7.825 – a great result.
Figure 3. Order sequence and results from trading platform
Figure 4 demonstrates clearly how this was a low risk, high probability trade, whereby the market itself has actually gone on to fill the gap after a potential energy – kinetic energy correction – impulse sequence.
Figure 4. Filling of the DAX opening GAP on the M5
DAX Gap Trade: Discussion & Analysis
Rarely does ‘top guessing’ offer benefit to the trader, except in the case of opening gaps, and/or high level confluence clusters which offer reasonable limit order entry solutions.
A forthcoming post will detail the use of the commodity channel index (CCI) in much more detail. For now, the key to the chart is that the red arrow ‘caps’ above the candles indicates that the relatively longer term or trend CCI (in this case set to 15) has ‘overshot’ to a level of 280 or above (in the case of upward momentum, -280 in the case of downward).
Three of the red caps in a row often indicate an imminent correction or reversal.
The white ‘caps’ on the candle tips are an indication of the period 5 CCI having hit its ‘overheated’ or ‘overshot’ mark of 167 (166.6 recurring).
Divergence on the RSI-7 indicator
The RSI-7 indicator is in the second indicator window off the chart. Divergence means that while the price has risen, the RSI has fallen, or while the price has fallen, the RSI has risen (classic divergence). This is seen as white trendlines on the chart.
As can be seen, there were two clear divergence set ups, the second, more steep divergence right before our second entry, and which acted as the guarantor of the reversal.
Probably the perfect entry was at the close of the 8.05 AM London time candle (marked 10.05 on the chart) because this was a ‘normal reversal’ candle. Our aggressive entry used ‘reversal condition 2’ – which will be discussed in another post – and refers to a break below the high of the candle previous to the prior candle (i.e. at time minus two periods, t-2), in a down reversal, or a break above the low of the candle previous to the prior candle (i.e. that at t-2) in the case of an up reversal.
Stochastics & WPR_MA
Although they were not really utilised in the trade, note that the stochastics were in a prolonged overheated mode above 85, and the WPR_MA WPR (William’s Percentage Range (21) with moving average (8)) lines were beginning their descent towards their average, the top and bottom versions offering multiple timeframe analysis – M15 and M5 in this case.
Summary of trades
This trade used knowledge that an opening gap is often filled with a range of indications of a reversal. The first trade was cancelled due to a continuation away from the gap. The second trade failed. The third trade, similar to the second, succeeded in following through, for a 1:7.8 risk to reward. Therefore 1 unit was lost, and 7.8 gained.
Learning points for trading journal
The initial trade exceeded the 1:7 risk reward by double, simply by filling the gap. Consider in future 2-3 units with a more reasonable stop, e.g. double or three times the stop used in this trade, closing out 1-2 at the first target, or 1 at the first target, 2 at the second target (twice the height of the first rectangle shown in figure 5), stop to breakeven, and 3 with a trailing stop to let the market run.
Target 2 projection
Figure 5. Projection of height of the first swing above the gap in the downward direction.
In figure 5, the height of the first swing above the gap is taken as 34 DAX points (the green rectangle shows this until it is broken to the downside.
The height of this move is then projected downwards as a further move of 34 DAX points, providing a second target.
About the author
Dr Samuel Alexander Beatson gained his PhD from the Research Centre for Banking & Finance at the University of Nottingham in 2015. He has taught financial markets analysis for more than ten years, including during a two year position at King’s College London, as a researcher and fellow at the Lau China Institute. He is the head of trading and market analytics at Quantisi Ltd.
Freddy FastTrack’s FastTrackForex.com quote of the day
The idea here is to accept small losses, but to stay in for the big winning trades.
Top 3 Trading Moments from this trade
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