The Crazy Game of Risk & Return (when gappin')
4 Comments Wednesday, February 25, 2009 at 10:07PM Gap Guy tagged Dow, Nasdaq 100, Russell 2000, S&P 500 in Gap Basics, Gap Size, Stops, Targets 
This morning's gaps in the indices were all in my "U-CO" zone (i.e. prior day was Up, and gap was below the prior day Close and above the prior Open. See Gap Zone Map.)
The new Probability Guides (at our new site) showed that today's gap setups for the ES, NQ and YM had strong historical win rates and profit factors when targeting the gap fill by going long at the open using a stop equal to 30% of the 5 day ATR. Plus, seasonality favored the longs today.
As such, as I shared pre-market with members, I planned to buy the open with a half size position in the ES, 8 pt stop and target 1/2 pt in front of gap fill. The requirement was that price be trading below 766.5 at the open so that I would have at least 2 points ($100 / contract) of profit opportunity.
Using TradeStation's time activated order functionality I set up my order with these parameters. The ES opened precisely at 766.5, but then traded below that price almost instantly, resulting in me getting filled at 766.5. Argh. I didn't particularly like the setup, but couldn't deny the historical probabilities. So, there I was filled with 1.75 pts of opportunity and an 8 pt stop (30% of the 5 day ATR).
Fortunately for me, the probabilities worked in my favor, and I was filled for a 1.75 point profit ($87.50 per contract) just minutes after the opening bell for my 2nd small winner in as many days and my 4th winner out of 5 opening gap trades this month.
Several folks told me in the Trading Room today that they have a hard time risking 8 points to only make 2 points. To be clear, it's not my favorite thing to do either. But for today, the Probability Guide showed a 78% historical win rate for gaps in this particular zone. That is the WEIGHTED average for all size gaps historically in this area. So, you know that the small gaps must have an even higher historical win rate and the larger gaps must have a slightly lower win rate.
Here's the math: Since all size gaps in this zone average a 78% win rate, let's assume that 2 point gaps have an 85% historical win rate (consistent with the average for small gaps in all zones). Out of every 20 trades, you would expect to have 17 x 2 pts of profit for 34 total pts. And you would expect to have 3 x 8 pts of losses for -24 pts. So over the course of 20 trades you would expect to make a net of about 10 pts (34-24), or about 1/2 pt (+$25) of profit per contract per trade. I've done this exact trade many, many times over the years and though it is not the most profitable of setups, they do add up over time.
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Reader Comments (4)
Hi Scott,
I was at your recent seminar this past Monday in NYC. In reference to today's post I too would have trouble risking 8 to gain 2. However, the more information I learn the more comfortable I am with the system. Thank you for such a great seminar and for the follow-up on this site.
The one thing I would add (which I didn't have time to discuss on Monday) is that I can't help but think from the examples given that it might be well worth your time to come up with a 'second entry' system. Either on time or maybe half of your stop (i.e. today the first buy at the open and the second at down four points). This could give you much better averages on the days that the market initially goes against you (which for me is quite often).
I intend on trying to develop some sort of system along these lines and begin keeping a log of it. If I come up with anything of significance, and you'd like, I'll keep you updated.
Thanks again,
-Glenn
Hi Glen - thanks for the kind words - the seminars were a lot of fun. It's always fun to share different views.
You are probably right regarding adding a second entry for those trades that go against me initially. Though I haven't quite figured out the right approach yet. The challenge is that the win rate is so much lower - of course this would be compensated by the larger average profit per winner. The other challenge is standardizing the entry rules to eliminate/minimize the risk of discretion and subjectivity (i.e. the "me" factor!)
I'll keep noodling and certainly would be interested in anything you learn.
Scott
I tried my first attempt at a gap this morning and it worked out great! I shorted the open (28.78) using the QQQQ with a .40 cent stop (based on 30% of the 5 day range (1.3 pts)) and looking for 28.59 as my exit (2 -1 risk/reward). 9 min and 15 seconds later I filled. It was a lot of fun and I look forward to another set-up I'm comfortable with in the very near future. As a side note I would have added a second entry at 28.98 but the opportunity did not present itself.
If anyone has any input I'm happy to hear it. Thanks.
Great news Glenn - thanks for sharing!