Understanding The Odds:
Trading The Opening Gap in the Mini Index Futures Contract

By Bob Hunt

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As the market nears its opening bell, and actual gap size is better known, we then concentrate on a set of statistics that describe the odds of price returning to the prior day closing level. Using gap level historical price information, market-specific probability of closure can be calculated and displayed as a known value just prior to the beginning of each trading day (chart below). This information is dependant on the direction and size of the gap, and can tell us what the chances for full closure happen to be along with the odds of half-gap closure (which are always greater than full closure). We can also determine the probability of closure based on the current day of the week, as well as note any other significant variables that may effect the probability of gap closure (such as special precautions necessary on the day after Options Expiration Friday or on "first Friday" Employment Report Days).

With this information in hand, and assuming the gap size is tradable with a high probability of closure, we can then begin the day with an eye towards placing a trade in that direction. Some of the variables that are best monitored just prior to placing a gap trade are (1) price action relative to significant support and resistance levels (i.e., regular session highs and lows established on each of the prior two trading days), and (2) NYSE Tick readings as a sign of short term trend exhaustion. It is especially important to measure the market's current state of expansion/contraction. Is the market currently trading in an ever-tightening range, or has it instead just begun a strong move in a direction opposite gap closure? An indicator called the "Volatility Expansion Meter", referred to as "Vol-X" in the chart below, can tell us when, and in which direction, a big move is likely to begin. If Vol-X is firing a signal in the opposite direction as gap closure, we definitely do NOT want to place a trade in the direction of gap closure. Rather, we would want to be looking for a trade in the same direction as the gap. Although a detailed explanation of Vol-X is outside the scope of this article, the standard application of Bollinger Bands can provide a similar, although less precise, glimpse into these kinds of internal market dynamics.

As an example, please refer to the chart below, which depicts an opening gap trading opportunity in the Dow Jones Mini contract. The indicator in the top left screen reports gap size, direction, and accompanying statistics prior to and at the moment the market opens (all time references are basis the Central Time zone). This indicator tells us that the odds for closure are high, and that we want to look for an early opportunity to get long. The "Leading Market Sectors" chart directly below the gap statistics display tells us that the three sectors that often lead market activity are starting the day with a definite bullish bias, adding even more reason to be on the long side. In the large one-minute candlestick chart we can see that "Vol-X" has not fired a signal to the short side, which indicates that range expansion lower is unlikely. Perhaps the most significant factor affecting our decision to take this trade is that the NYSE Tick reading ($TICK) is unable to muster any momentum to the downside. In fact, it can't even break down through the zero level. The rise in Tick readings is our trigger into the trade, which gets us in a few points before the 10397 level of Today's Open is breached. A protective stop is placed just below the closest known support zone, which is that of S2 at 10384.

Charts created by Tradestation