A strategy for gap trading the opening bell

Most mornings I’m sat at my desk at 7am, when markets open.

And, as a trader, I feel a strong draw to this opening few minutes – that I should be in the market, acting.

We traders never know WHAT the markets will do … or WHEN. Which is why market open is so attractive – because it gives us an insight on timing. We might not know what’ll happen – but we can be pretty confident that something will happen at exactly 7am each morning.

So, if the timing is done for us – that’s 50% of our trading puzzle worked out. All that remains is for us to take a punt on which way the market’ll go.

I don’t mean to sound flippant – this kind of window of opportunity is what trading is all about – we just need to tip the scales into our favour, get our risk-reward right, manage our exit … and bingo!

So, what happens when markets open?

These days, many brokers give overnight prices on indices. This means that they work out a price estimate while markets are closed, based on the futures market.

However, there are still a few brokers who don’t do this – and these are where we see market ‘gaps’ as the index finds is price level when it reopens.

Here’s a pretty typical overnight pattern on the FTSE …

The market closes on the Monday night at around 7097 … and reopens at 7am on Tuesday morning 17 points lower, at 7080.

Now let’s do a little refresher on gaps and gap trading …

Traders have a few sayings about gaps:

‘the market hates a vacuum’ … ‘the market will fill a gap’ … or ‘close a window’ …

The gist is that where we have a gap, there’s also an expectation that the market will come back and ‘fill’ that area of white space on the chart. (You can see it clearly happening on the example above.)

Sounds great, doesn’t it? Just open a trade each morning to ‘fill’ the gap on the FTSE?

But, of course, it’s not that simple.

The presence of a gap indicates momentum in the market, and it’s not always the wisest thing to stand in the way of that momentum. Yes, the gap may be filled, but it could take too long, and move too far against you in the meantime. (See more about gap trading here.)

So, how can we take advantage of that opening bell momentum – without getting stampeded by it?

Let’s look at what happens in the first few seconds, as traders pile through the doors. Here’s a 1 minute chart of the FTSE open …

As you can see, there’s a fair bit of volatility in that first minute. If you got in too soon to try to close that gap, you’d have needed a wide stop to avoid being knocked out by that activity (remember – these candles only represent a few points, so the price could well be bouncing about wildly within its limits during that first minute).

If you’re trading these market-open gaps, you’re looking for a handful of points in profit (plus, the cost of the spread makes up a big percentage of that move), so every point matters in these trades – you can’t afford to get in at the wrong level.

So, what if we wait 5 minutes for the stampede to die down?

Here’s the same open on a 5-minute chart …

Adding the 5 minute candle to your gap trading strategy

As well as keeping us out of trouble, waiting that extra 5 minutes can give us another profit opportunity. Where the market has made a big move in that first 5 minutes, further widening the gap, we have a few options:

1. Enter the trade at that better price, so making more points profit.
2. Setting an order to open the trade when it retraces to market open price.
3. A combination of these: by entering the trade immediately, but closing out half of the position at market open price.

It’s noticeable that, even in scenarios where the opening gap isn’t filled, the price will retrace to the open price before shooting off …

Opening bell strategy rules

If you’re tempted to try your hand at trading the opening bell, there are a few important points to remember:

• The gap needs to be big enough for you to collect a reasonable profit, bearing in mind that on the FTSE, you’ll be paying around 1 point on spread costs. Don’t be tempted to go chasing after ‘fills’ of less than 10 points – it’s not worth the cost, risk and effort.

• Likewise, if the gap is too big – beware. This could be a runaway gap (see below).

• Keep your risk-reward tight – yes, gaps will often fill, but they also often won’t (or not in the way you want them to). So you’ll need a tight stop so you stem losses fast if the market doesn’t behave.

• If the gap has already filled (or reduced too much) in that first few minutes – the opportunity just wasn’t there, so sit out.

• If there’s a clear news story or event that’s driven a market gap that morning – this could be what’s known as a ‘breakaway’ or ‘runaway’ gap. This isn’t your common-garden gap, and you should beware these events. Volatility may well not calm down within the first few minutes, so you could experience gapping in your trade (i.e. getting stopped out of a losing trade at a worse price than you expected).

• Remember that trading the opening gap means standing directly in opposition to market momentum – this isn’t always going to be a comfortable place to be.

I’d be really interested to hear your methods … your successes … and what you’ve learned trading opening patterns. These systems are very enticing to traders, but need a steady hand …

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