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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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As compared with single-item markets, a multi-item market such as the E-mini S&Ps or the mini-sized Dow futuresIt's like quitting smoking. Either people choose to light up another cigarette or they do not. They take it one day at a time. For each day they don't light up, the better the odds they will never smoke again, ft is no different in trading. For each day traders can actually be totally disciplined and follow their setups exactly as plannedeven if it means standing aside when the market is racing away without themthe better the odds they will make it in this business. If you want thrills, go to Disneyland. Although I can't stand over your shoulder and help you with your discipline, ] can show you the setups that I use to trade for a living. I have loosely organized these in the order tnat I look at them throughout the trading day. As you try these out on your own, you will find that you naturally gravitate toward some rather than others. Key in on this, as a trader will tend to move toward setups and markets that seem to fit their personality. Let's jump right in with the first setup and one of my favoritesthe opening gap play. NOT ALL GAPS ARE CREATED EQUAL I find gap plays to be the best way to start off my trading day. Not only are they the first trades of the stock market session, but, more importantly, they can also tell a person a lot about the upcoming market action for the day. Because of this. I spend more time talking about this setup than the others. Gaps are contrarian plays, or fade plays as I like to call them. Opening gaps create a lot of excitement and emotion in the market participants, and I like to step in and take the opposite side of this emotion. The play is completely against the crowd, which I like, and is one of the lowest-risk trades available. What exactly is a gap? Gaps occur when the next day's regular cash session opening price is greater or lower than the previous day*s regular cash session close, creating a gap in price levels on the charts, similar to that space we see each night between David Letterman's two front teeth. It is important to note that traders will not see this gap on their charts unless they specifically set up a gap chart. With a 24-hour chart, traders will not see the gaps. This is discussed in more detail shortly. When it comes to gaps, not all markets are created equal. Gaps in single item markets do not act the same as gaps in multi-item markets. Examples of single-item markets include bonds, currencies, grains, and individual stocks. These gaps typically fill at some point, but not necessarily on the same day. For this play, I'm specifically interested in gaps that have a high probability of filling on the same day they are created. For these single-item markets, a news item controls the entire order flow for that day, instead of affecting just a small portion of an entire index. This is especially true of individual stocks. Individual stocks are like politicians, in that each day they can produce a fresh skeleton from the proverbial closet. Earnings announcements, corporate scandals, and insider deals can create gaps in price that never get filled. Ken Lay and Bernie Ebbers certainly wish their Enron and Worldcom stock would fill their overhead gaps. Unfortunately, the odds of this happening are about the same as getting the European Union to agree on a unified constitution. In other words, it's never going to happen. Because of the unpredictable nature of individual stocks, they make poor candidates for gap fills. The exception to this is gaps on individual stocks that are gapping with the market and not on any particular news. How does a person tell this? If a stock is gapping 10 cents for each one-point move on the S&Ps and there isn't any news on that stock, then that stock can be played as a gap play. For example, if KLAC (KLA Tencor Corp) gaps up 42 cents and the S&Ps are gapping up 4.00 points and there isn't any specific news on KLAC, then it can be played as a gap play. It's just moving with the overall market. As compared with single-item markets, a multi-item market such as the E-mini S&Ps or the mini-sized Dow futures, as well as their equivalent ETFs (exchange traded funds) via the Spiders (SPY) and Diamonds (DIA), make great candidates for gap plays. This is because there are individual components of these indexes that will respond differently to various news items. Good news for oil companies is bad news for transportation companies. Good news for defense stocks can be bad news for travel-related stocks, and so on. This means that, although the market may gap up on a news item, there will be individual stocks within the index that will either ignore the news or sell off on the news. This weighing down, coupled with an initial pullback in the strong issues that are gapping up, weighs down the entire index, creating an opportunity for the market to fill its gap. In addition, many fund managers watch the open gaps. They've been doing this a long time and know that the markets hate to leave messy charts in the form of open gaps. If the markets gap up, they will generally wait to start committing to the long side until the market has pulled back and filled its gap. In this way it is also like a self-fulfilling prophecy. What about the Nasdaq or the Russell? I've watched these markets as well, and although they do fill their gaps a large percentage of the time, that percentage is lower than the Dow and the S&Ps. In the end, my favorite gap plays are in the mini-futures and ETFs representing the Dow and the S&P 500, The Magic of Premarket Volume The great thing about gaps is that they are like an open window, and like all windows, at some point they are going to be closed. The key, then, is to be able to accurately predict when the day's gap (window) is going to be filled (closed). What is as important as analyzing the gap itself is analyzing the market conditions that produce the gap. The reason for the gap is immaterial, Upside earnings surprises, terrorist threats, takeover announcements, economic reportseach morning the markets are bombarded with news. It's not the actual news, but how the markets respond to that news that is important. To understand how the markets are really reacting to the news, all a person has to do is look at the premarket volume. In addition to news gaps, which are more or less fishing expeditions, there are also professional gaps. Professional gaps are designed to keep the retail investor out of the market. These occur when the Dow gaps up 100 points and then trades in a tight range for the rest of the day. The move essentially happened before the market opened, The professionals who were positioned for the move benefit, while the average retail investor is left with nothing and no opportunity to participate in the move. Again, premarket volume can tell a trader if the gap is going to be a professional breakaway event or is going to lead to price action that has a high probability of filling the gap on the very same day it was created. A professional gap with high premarket volume can take weeks to get filled. Much more common are gaps that are news reactions or fishing expeditions. These are smaller in nature, are highlighted with low to moderate premarket volume, fill quickly, and can be faded regularly. The question, then, is if I ignore the reason for the gap, what is it that I'm looking for that determines whether or not I will take the setup? Premarket volume in what, exactly? The key action I am watching is the premarket volume in a specific sei of cash stocks. I like to look at all the cash stocks that also trade single stock futures (SSFs). The list of these stocks is available at www.oncechicago.com. As of this writing there are about 120 stocksthey are all the big stocks that trade a lot of volume. Note that I'm not watching the volume of the SSF contract, Tm watching the volume of the actual underlying cash stock. I particularly like to watch KLAC (KLA Tencor Corp), MXIM (Maxim Integrated Products Inc), NVLS (Novellus Systems Inc), and AMAT (Applied Materials Inc). I like these stocks because they are traded actively in the premarket session and are traded aggressively by both individual traders as well as fund managers. Even though these components are not part of the Dow, they still provide a clear map as to how the market is handling any particular news that is out on the day. If the volume on these stocks is heavy, then it is obvious that the market is taking this news very seriously. If the volume on these stocks is light, which is more common, then the market is either not interested in the news or, more likely, has already priced it in. It is on these days that the gaps have a very high probability of filling on the same day in which they were created. What I'm looking for is the premarket volume in these stocks as of 9:20 a.m. Eastern. 10 minutes before the regular cash session opens. The premarket session opens at 8:00 a.m. Eastern, so these are data on 1 hour and 20 minutes worth of trading. If these stocks are trading under 30,000 shares each at this time, the gap (up or down) has an approximate 85 percent chance of filling that same day. However, if it jumps up to 50,000 shares each, the gap only has about a 60 percent chance of filling dial same day. On these particular days, however, the midpoint of the gap has an 85 percent chance of being hit, so I do take this into account and adjust my target accordingly. For example, if the gap is 50 points on the Dow and the premarket volume is moderate, then my target is going to be 25 points from my entry instead of the full 50 points, which would constitute a gap fill. Finally, if the premarket volume jumps to over 70,000 shares each, the chances of the gap filling that same day drop to 30 percent These are typically the days that involve a professional breakaway gap. On these days I don't fade it. I typically stand aside and wait for one of my other setups to unfold. Why does this premarket volume indicator work? Think about ii as driving a car uphill on an empty tank of gas versus a full tank of gas. If the market is really set up to move, then there will be real volume coming into the cash market to propel that car up and over the hill. If the market is just setting up a head fake, then the volume in the cash market will be low, as there won't be any teal conviction in the move. Ignore the news and follow the money. Table 6.1 shows how I use this information to manage my trades There are many days when three of the stocks are trading under 30,000 shares and another stock will be trading 95,000 shares, [n these cases, I will first check to see if there is specific news on that stock. If there is, I will throw it out. If there isn't, I will then take an average and call this a moderate gap and play it accordinglymeaning that my target on the first half will be 50 per cent of the gap fill instead of holding onto the entire position for a full gap fill. For moderate gap plays, I do not trail down the original stop, even when 1 get out of half my position. The Best Days of the Week to Take This Trade One of my trading partners, Hubert Senters, has compiled data over the last 4?? years based solely on the raw gap data, disregarding any readings on premarket volume. In Table 6.2, these data are sorted by day of the week and show what percent of the time the markets filled their opening gaps on the same day in which they were created. As is evidenced by these data, gaps in and of themselves have a very high probability of filling on the same day in which they are created. If a person could get these same odds at a blackjack table, Las Vegas would be put out of business in three months. That said, it is important to note that Mondays are the days with the lowest percentage of filled gaps. The main reason tor this is that most breakaway gaps happen on Mondaysthere are a lot of developments that can happen over die weekend. On Mondays I will still take low-volume gaps, but if the volume is moderate, I will pass on gaps that are over 50 Dow points or 5 S&P points. Finally, I've noticed thai expiration day (the third Friday of every month) and the first trading day of the month have low probabilities in the range of 55 to 60 percent. I generally pass on fading the gaps on these two days. The only exception is if the premarket volume is very low. The bottom line is that if the premarket volume gets confusing and a trader doesn't understand the reading on any given day, the odds are still there and the trade is worth taking. TRADING RULES FOR GAP DOWN BUYS (GAP UP SELLS ARE REVERSED) The set of rules for gap down buys is based on a low premarket volume gap. If the volume is moderate, then 1 will do exactly the same thing, except I will take off half my position when the markets reach the price level that represents 50 percent of the gap fill. If the premarket volume is high, then I pass on this rrade setup. Remember, this is a fade play. 1 will buy a gap down, and short a gap up. The following set of rules is for a gap down: 1,1 first set up a special intraday gap chart that starts collecting data at 9:30 a.m. Eastern and stops at 4:15 p.m. Eastern. This is so I can view the gaps. These gaps won't appear on charts that carry 24 hours worth of data or as regular session data on the futures markets. 2.A gap must be at least 10 YM points or 1 ES pointotherwise I will pass. 3- If a gap is over 70 YM points or 7 ES points, I pay careful attention to the pre-market volume. Most breakaway gaps are big gaps. However, if the premarket volume is low to moderate, I will still take these, 4* With a gap down, when the regular cash market opens at 9:30 a,m. Eastern, [ buy the YM or ES at the market. The DIA and SPY can also be used. It doesn't really matter which market is utilized, with two exceptions: If one of the stocks in the Dow is out of whack then I will play the gap in the S&Ps. By this I mean that if a stock like IBM is up 10 points on earnings, then this index is going to be '*out of whack with the rest of the markets. The other exception is if I am specifically using the Dow in another setup, say the squeeze or a pivot play (these are discussed in upcoming chapters). Then I will lake the gap in the S&Ps. This way if I am still in the gap play when this next setup fires off, 1 can just take it in the Dow and leave my gap trade on. 5.Once filled, I set up a protective sell stop with the following parameters: For gaps that are under 40 YM or 4 ES points. I use a 1 /:: 1 risk reward ratio. (Example, for a 20-point gap, T use a 35-point stop), For gaps that are over 40 YM or 4 ES points, I use a 1:1 risk reward ratio. (Example, for a 45-point gap, 1 use a 45-point stop). 6. My target is the gap fill itself. If yesterday's closing price was 1058.50 on the S&Ps, then that is my target for the gap fill. For a moderate volume gap, I will split this order up, having half my target at 50 percent of the gap fill, and leaving on the remaining half for a potential full gap fill. 7. I don't trail stops for this setup. 8* If I'm stopped out. then the gap play is over for the day. 9. If neither the target nor stop is hit by the closing bell, I exit my position at the market. 10* For the gap play, there is only one potential setup per trading day. WHO IS GETTING A SPANKING AND WHY? One of the most important steps for traders is to understand why they are making money in a particular tradewhich also means understanding who exactly is losing money on the other side of the trade. Who is getting hurt and why? When markets gap down, there are generally two groups that are going to get hurt. First, there are the people who are long from the day before. When the markets gap down, they are either getting stopped out or they are panicking and selling. Second, there are people who are flat, see the gap down, think it is the end of the world, and start shotting. In this setup, I want to be on the opposite side of the trade from both these groups, because both of them are having a strong emotional reaction to the market, and this emotion is causing them to get into a trade. Therefore, when they are selling, I am buying. These same groups will provide the fuel for the rally through, in the case of the first group, panic buying in trying to make hack their early losses, and, in the case of the second group, short covering via the stops they placed when they put on their short trade. Let's take a look. The charts that follow are numbered in specific places where price action is taking shape. Each of the lists that refer to the chart are numbered so that the text following 2 describes point 2 in the chart to which the text is referencing, SPECIFIC EXAMPLES OF TRADING THE GAP Mini-Sized DowDecember 2003 Contract, October 15, 2003 1. The mini-sized Dow contract closes at 9717 on October 14 (see Fig. 6.1). 2. On October 15, the opening trade at 9:30 a.m. Eastern is 9762, producing an open ing gap of +45 points. 1 fade the gap right at the open and short the YM at the market. My protective stop is 45 points away from my entry, at 9807, and my target is the gap fill, which is the previous day's close at 9717. 3. The gap fill is complete once the price levels reach the previous day's close. This occurs 35 minutes after the opening bell. This is a relatively smooth trade. I refer to these quick fill gaps as Bahamas Gaps because they are relatively smooth, quick, and stress free. This trade nets a profit of $225 per contract Mini-Sized DowDecember 2003 Contract, October 16, 2003 1. The market closes at 9704 on October 15 (see Fig. 6.2). 2. The opening trade at 9:30 a.m. Eastern on October 16 is 9645, creating a 59-point gap down. I buy at these levels and place a stop at 9586. X Many people who play gaps would get stopped out right here at point 3, as they trail up their stop to break even to protect gains. For these people, the gap play is now over. 4. Yet by holding onto this play with parameters that were made especially for gaps, I end up staying in profitable trades that shake many other traders out (see Fig. 6.3). The reason for this is that the other traders are using blanket types of parameters for every play, instead of utilizing specific parameters that are tailored for specific plays. Although many gaps fill within the first hour, many can take a couple of hours or more. I like to set the parameters and focus on something else while the market does its thing. I refer to this type of gap as Somalia Gaps. Unlike Bahamas Gaps, they tend to cause a lot of stress in the people who are watching them. It's okay to feel stress; professional traders simply don't act on it, maintaining the parameters they have set for themselves. This trade nets out a profit of $295 per contract. |
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