Tuesday, September 27, 2011
Price Action Basics V: The Open Gaps
The open is a very complex set of topics and gap opens are an important source of information about the day's price action. Occasionally, the market opens very near to the close of the prior day (less than one average bar). This usually can be traded as if there was no gap and the open is simply continuation of the prior day's price action. Usually, the open almost always is a few bar lengths away from the close of the prior day. This is a small gap and usually this acts like a breakout or a trendline break. Usually, the market attempts to close small gaps giving either a pullback from the gap breakout or re-test after the gap trendline break. Sometimes small gaps will extend before closing and this will lead to a protracted trend after reversal. When a small gap extends, you usually have no idea how far it will go but you always know that the reversal will test the close of the prior day.
Gaps that give an open within the body of the prior day, especially mid-body are suspect. No matter which way they trend, they are likely to reverse sometime within the day.
In other words, most days are likely to trend trying to close the gap. Naturally, if it tries to close the gap in two or three attempts and fails, the market will usually give a large trend in the opposite direction. Keeping the above in mind is very important to determine 1Rev correctly.
The last case is the large gap (about a day's range). A large gap can lead to a large trend if it tries to close the gap. If it tries to extend the gap, it often behaves like a spike and channel with the gap as a spike. This often means its a soft-trend day. A large gap down can give a hard trend if it tries to widen the gap.
However, a large gap simply gives a trading range, which can lead to a gap closure late in the day (as in today's chart). A good metric for the trendiness of a large gap is the first bar, which if its a average sized trend bar is likely to lead to a large trend day. A doji or other poor bar such as today's b1 usually indicates a poor AM trend.
Determining the likely primary direction of the day improves your chances of a successful 1Rev and 1PB entry, which in turn allows you to swing for larger number of points and increases your profitability.