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.

2 Failures to close gap

On many days when the market opens with a reasonable sized gap (4+ points), the market will try to close the gap twice. If it fails on both attempts, there is a high probability of a strong trend in the direction of the gap before the market tries to move against the gap.

The larger the gap, the larger the trend move before any attempted reversal.

Today opened with a reasonable gap and a doji bar b1 with a close near the low of the bar, which is a poor signal for a long and was likely to fail. The second signal was another doji but with a higher close and was also a failure. The presentation of poor counter-trend signal bars is a strong indication of continuation of the trend.

Two failures led to the market breaking into a trend and extending the gap all the way to bar 14. On the way, a fH1 at b9 marked a precise exit near the low of b14.

Video of trade available on youtube

Signs of counter-trend strength in a gap open

Large gaps tend to widen rather than close, since something fundamental would have changed to cause the large gap. However sometimes a large gap will attempt to close and will trend for the rest of the day, often closing at its high.

The first bar after open (b1) closing opposite to the large gap is usually the first sign of strength. If its an average size trend bar or a reversal bar, its a very strong sign. (If the gap is small, the bar could simply act like a pullback and should not be considered).

A b2 triggers such a b1 and closes strong is a second good sign. If b2 attempts to widen the gap and fails giving an fBO (b3) its also a good sign.

1tfs (b7,9) and 5tfs on attempts to widen the gap are the next signs to look for.

Strong trends will usually have shallow pullbacks and average sized bars instead of deep pullbacks and large bars.

Wedge Failed breakouts

Often when the gap on open is large, there is an expectation of a trend move. While trend from the first bar is a reasonable expectation, some gap days will only result in a trading range. However, on some days you will see a wedge attempt in one direction that will take out the low of the day and often result in a measured move of the opening range.

The Wedge on open could form either with the gap or against the gap. When the wedge is with the gap as in today, it often appears as a variation of a 2-legged pullback to the ema.

To identify wedge on open, look for a large first bar (signifying TR), preferably with large tails (also TR) or overlaps (b3,4 -- also TR). After the initial move, the market will move in three pushes in either direction and give an entry fading the range. When the wedge move reverses the initial move and takes out the range extreme (b1 high), its a wedge failed breakout or WfBO. WfBOs are trend generators and should always be taken as a swing setup. At the very least they give two legs, often taking out the other end of the range. If the range is taken out in one leg, they often give a measured move of the range.

Trading plan: Trend day

Trading on trend days is relatively easy and trading only on trend days and sitting on the sidelines on the rest of the days is a viable trading plan. The only issue is that trend days occur infrequently (about 20% of trading days) but on sharp moves on the daily chart, trend days can occur a lot more.

The first step is to identify a trend day. Overall there are some common attributes but these do not automatically guarantee a trend day.

• A large gap (beyond the range of the prior day) and a large opening bar that widens the gap
• A large gap that fails to close in a 2 or 3 legged move
• A small gap that reverses the high, low or close of prior day
• A small gap that moves to ema and reverses
• First 3 or 4 bars make a trend move

In all the above, you can simply take the 1st pullback and swing for the rest of the day. The 1st reversal (b5 or b6) and the 1st pullback (b9) are often very poor bars so a conservative trader may simply wait for the first 2 legged pullback. On many days this means missing a large portion of the AM move but a 2L pb is far easier to enter.

The main thing to watch out for in a 2 legged pullback is the quality of the signal bar. Often the first signal bar is a trap. For example b24 was an outside bar and b33 was a doji. b47 had a tail on the entry side, was away from the ema and was strongly overlapped by prior bars. In such cases, you should simply wait for the next signal. You will know your entry is correct when your signal bar is strong (b37) and after it closes, the breakeven stop at your entry price will not be hit.

You should always be on the watch for possible trend terminations such as a double top, W (b75), TTR or a trendline break. After this point, there may be no more A2s.

Once you can trade trend days adding trading range days is easier. On the setup chart most setups are in trend moves. In trading ranges there are basically only breakouts and failed breakouts and those take a lot more experience to trade profitably. You can be a profitable trader without ever trading trading ranges if you are able to sit out on 80% days.

Very large gap up

A large gap acts as a spike and if the price is very far from the ema, its very likely to pullback close to the ema. A 2 legged pullback to the ema is a very strong signal on a large gap day. The larger the gap, the deeper the initial pullback (b1-b14) and may look like a mini trend.

Just like a day that opens with a large spike bar, a very large gap day is likely to act like a soft-trend day with very shallow pullbacks. When the first higher low is a fL2 (b19,b22), its a very strong sign of an impending soft-trend day and you should never trade counter-trend.

On a soft-trend day, you can trade above doji bars (b42,58) as if they were bull bars provided they are close to either the trendline or the ema. When in doubt, you can always trade above a strong bull bar following the doji signal bar (b43,b59)

Large gaps

Large gaps -- gaps that are the size of an average day, currently about 10 points in ES -- are likely to move away from the gap rather than close it. This usually implies a trend day. A large gap day that tries to close the gap usually ends up moving far beyond the close of the previous day but a gap that tries to extend its self may find resistance and the early price action gives some clues.

A strong move up early on strong trend bars usually means possibly a large day and a early move of overlapping bars with tails may mean limited movement after the early move. A shallow trendline break (b15-25) may mean a trend termination without a reversal. Often on strong days such as this a strong AM trend and a shallow trendline break is followed by a channel type move. This is because on a higher timeframe this actually is a spike and channel. The channel should never be shorted until it has its own trendline break (b50-55) followed by a test of the extreme.

In general, large up gaps followed by a trend made up of average or small bars is fairly easy to trade if you take only with trend entries near the ema. A rough rule of thumb is to only trade with-trend near the ema until there is a successful close below the ema (b57) and then exit on the next push up (b67).  Buying second attempts above bull bars only will usually protect you from being stopped out.

Anticipating AM trend reversals.

I have often stated that consistent success lies in the ability to get in on a trend early, especially the AM trend. Often an absence of an AM trend may mean a potential PM trend if the day opened on a large gap but on many days its just a TR day (regardless of gap).

Occasionally, however, we get an excellent AM trend which breaks and instead of turning into a trading range, reverses into another excellent PM trend.

To anticipate such moves, watch for a large gap and an open within the range of the prior day (b1). If the trend move breaks an extreme of the prior day in three pushes (b5,10,18) and gives a reversal signal (b18), there is a very good chance the next two legged pullback (b45) will break into a trend. This trend should be expected to at least take out b1 and therefore is an excellent swing candidate.

The open: Trendlines, Gap and setups

Shallowest Trendlines

The price action of the prior day give rise to two trendlines -- the shallowest bull and the shallowest bear trendlines of the prior day. The shallowest bull trendline is drawn from the lowest point of the day and touches another point such that all the price action past the lowest point is on one side of the line. The trendline should not be concerned about the price action before the low of the prior day. The shallowest bear trendline is similar from the high of the prior day.

When there are multiple points that are at the same point, as in bar 24,25 lows shown above or when the lows are formed by a double bottom of two separate swing points, simply use the most recent as the low of the day, i.e. do not draw a horizontal line.

When the next point is very close as in b28 above, the trendline could be shallow and inaccurate when drawn manually.

The price action of the current day should be expected to react to the trendlines from the prior day and then make a significant move.

If the last bar of the prior day is the highest bar of the day, there is no shallowest bear trendline. On the other hand, you can draw a shallowest bull TCL. TCLs are less significant than TLs and are only used for reversals when the price opens beyond it.

Gap

When the price action of the day opens well beyond the trendlines, the trendlines may not have any significance. When the gap is small (3 to 5 bars distance), a test of the line is likely to occur before any strong trend move. If the price opens between the two lines, there is a good chance of both lines being tested before any significant move.

If b1 of the current day overlaps with the last bar of the prior day and the prior day ended mid-trend move, then for all practical purposes, the open can be treated as its a continuation of yesterdays trend and the shallowest TL from the prior day be treated as the trendline for support, setups, etc.

Chances of an early trend

When b1 of the current day overlaps with the highest and lowest bar of the prior day, or the prior day ended in a large trend leg and b1 of the current day overlaps the last bar of the prior day, chances of an early trend including trend-from-open are high. When the price opens near to the shallowest trendlines from the prior day, it also increase the chances of a significant trend during the open (first 12 bars). On such days, look for 1P setups. You should hold a swing position since this could be a large move.

1W

1W is the default open setup. If nothing else happens within the first hour, its likely that the price will give three pushes in one direction and try to reverse up. In general, opposing bars b1 and b2 represent the opening range. Three pushes beyond to b11 represents the first 3 push of the day and should result in an attempt to reverse the W, i.e. take out the other end of the opening range. If the W succeeds in reversing in one leg, then the price should be expected to at least go further to the measured move of the W.

The first reversal

When there is a large gap (larger than a recent day) and the first bar forms a reversal bar trying to reverse the gap, it can be considered a first reversal. Today was only marginally a first reversal since the gap was relatively small in terms of points and the bar closed just above the high of yesterday. When there is some doubt as to whether a reversal bar is worth taking, it sometimes helps to see the first five bars of a 1 minute chart.

As you can see from the chart, there was no bull strength during the first five 1 minute bars. No bars went above the previous bar or closed up strong. Such a first bar is worth shorting.

On 2010-12-21, we had a similar bar but shorts below it ended up in a one tick failure (1tf). Yes, the bar overlapped the previous day just a bit, but that by itself is not a show stopper.

Zooming into a 1m chart shows us how the bar was different. The first three minutes had strong bull action and bulls simply saw the bear bars as a buying opportunity at a better price.

Especially on a possibly small range day, its important to get in early on a possible AM move. First reversals are an important part of this trading principle.

TTR trend terminations

Trends can terminate into a TTR after a large move up and this includes large gaps. A TTR that slopes up after a pullback will often make a double top or nominal HH or LH. If on the other hand a TTR slopes down from the high of the day, then it may make a two legged or three legged move near the high of the day and then move down.

BW early in the day as we saw near b6 is often an early sign of TTRs and soft trends and one should take trades very carefully. Once the TTR has terminated the trend, the next move is to wait for a trend breakout such as expanding triangles or DP. Any two legged move can be traded if the range is large enough. Today the range was barely 5 or six points so you would risk about 2 points to essentially make 2 points or less. Normally, its best to avoid trading at this point.

A huge gap up day that does not go anywhere is often a consolidation and a gap on the next day is likely to  extend the gap and turn into a trend day.  

The January effect

A large gap and a move up on the first trading day of the year is generally considered a good omen and a predictor of a bull move for the next few months. When the market closes near its low, the strength of this assumption is weakened.

On many years, this is an expected gap open and some traders will take a long position on the last trading day of the prior year and exit on the open for a very good profit. This is still gambling however, since a gap down can wipe you out.

Trading based on a large overnight move is speculation and should be done with caution. A small position may be taken using call options, but a larger position required a spread, butterfly or other limited risk option strategy.

Earnings, interest rate changes, government announcements, etc can also be traded this way.

Correction: The original chart showed a buy above b6 on the fL2. The actual buy was at around the same price but above the first bar of the 3m chart as shown below.

The first reversal

The first reversal (1Rev) is a reversal after the first trend move of the day. This should be distinguished from a simple failed breakout such as a 1tf or 5tf of the first bar of the day. A fBO of the first bar (or even later bars) cannot be expected to make a large move, but a first reversal of a trend move usually does.

There are many kinds of 1Rev. A reversal after the first successful scalp trade or at least a 6 tick move from the close of the previous bar is a type of 1Rev (b7). A reversal after a trend move however, is usually the best kind of 1Rev and is often the low or high of the day. A reversal bar after a large gap can be considered to be a first reversal since the large gap represents a trend move.

If the opening gap is small or non-existent, it is best to wait for a trend move away from the first bar and take its reversal. Reading all variations of this is complex, but a simple filter is to take the reversal after the first two legged move of the day (b15). If this reversal gives a small two legged move in the direction of the trade, you should consider the possibility of an A2 setting up and you should exit your position and reverse on the A2, which is a kind of 1PB trade.

Even if you never trade 1Rev or just scalp it, its useful to keep track of them since the 1st pullback after the first reversal (b27) is usually the best 1PB move of the day.

Consolidation after gap

A narrow horizontal day after a huge gap up is usually a consolidation day. This is when the overnight traders take profit and the ones who missed out on the big move enter. Usually this leads to a large move in either direction in a day or two.

If the next day gaps down, this could lead to a large move down and in principle is similar to island reversals on daily charts.

A day like this is traded like a normal trading range day and if you traded any two legged move, you probably did well.

TCL test on open

A TCL test on open may indicate the direction of the AM trend. A second failed overshoot of one or more TCLs from yesterday may indicate a reversal or at least a 2L move away from the TCL.

When the gap is small, this can be simply viewed as a climax bar and a W type reversal on overshooting the TCL. If the gap is large, this often leads to the formation of a reversal bar and a possible trend from the 1st bar.

Drawing the TCL from the prior day prevents you from taking an entry in the wrong direction and is especially helpful after a strong trend day or two.

A hard Wedge reversal

 Due to the large gap on the open, I could trade the 1 minute chart on the open. The opening range (b1 to b8) had a failed Breakout with double bottom on b15.

From there the price moved up three pushes to a wedge (W) at b30. This short could be held until the W reversal further in the day.

A reversal bar above a large gap is always a good trade for a scalp at least. Today, your scalp would have worked but your swing portion would be stopped out for breakeven. On days like this, many traders miss a good runner unless they re-enter on the 1 minute chart, which provided a W entry. Even on the 5 minute chart, a micro-W was clear due to the three spikes up.

The double bottom up down at b11,12 is a possible reversal, however with 5 bear bars against the buyer, it ended up working like a trading range. A short above which proved successful.

b18 technically was a W, but its signal and entry bars closed weak. This led to a further A2 short off b24 on a less than desirable looking signal bars.

b29 was a very strong wedge and was a great potential swing trade. So were the A2s at b40 and b65.

Shorting b22 and b55 proved profitable today, however in general these trades are dangerous. There was possibly a W reversal before b22 and b55 could have been a trap for one more leg up. These trades can be taken with lighter size only but leaving out lesser probability trades is the best option in the long run.

Fading a strong trend instead of trading with trend

One of the classic trader's error is to fall in love with their first position. If a trader bought b2 since he may be expecting gap closure or b5 as a possible second attempt to close the gap or 1PB, he may be surprised when the market stops him out and takes out the low of the day.

When he later sees b9, he may see a reversal bar. b12 may appear as a reversal bar after a possible 1 bar FF at b11.  b12,13 may appear to be a rather strong 2 bar reversal. The trader may end up buying every one of these and getting stopped out every time. (The alternative, adding on at every new signal is far more dangerous).

One of the reasons I prefer to trade on breakouts of signal bars rather than simply buy on close is that it prevents me from entering into many incorrect trades such as these.

The complementary situation  is the trader who was right about the initial direction but fails to see the trend break (b19-b27) and test (b49) and insists on shorting every move up. After a major reversal at b49, there are no more short trades and b58 therefore is not an A2 short. (A common reason for failed A2s is being in denial about trend termination or trend reversal).

A common reason for such behavior is the trader's bias about market direction. This bias may be a fundamental bias caused by reading too many economic blogs or watching TV or other inherent biases about the strength or weakness about the world economy that the trader wants to see reflected in the market today.

Traders who don't watch news are possibly subject to technical bias. They may have an inherent belief in some pattern or indicator and are expecting a strong reaction. It is correct to trade those and natural for some of them to fail. The trader however, should not repeatedly enter a trade in the same direction assuming he would eventually be proven right. This is the need for acceptance and is a strong human trait. You should not let it meddle with your trading since the market is too impersonal to either accept or reject you.

The trader needs to realize that all biases and opinions are always wrong regardless of their direction. Only the market is right and for a day trader, the strength and underpinnings of the economy are meaningless. Patterns and indicators are tools and they fail occasionally no matter how reliable they may have been.

The right way to trade is to accept only what the market presents and be aware that trends can break, trading ranges can breakout and nothing is guaranteed to run forever or reverse eventually.

The first pullback

The first pullback after a trend move (1PB) is usually the best swing trade of the day. A trend move could be a large gap, a large trend bar or a channel move. The stronger the trend, the better the 1PB entry. This move is especially strong if it forms a 5tf off the first entry (1PB signal bar b5 hi was 5tf from b2). A second form of 1PB is the first 2 legged pullback (b24). When the 2 legged pullback is to the ema, its no different from an A2, but the first such entry is likely to give you the best swing move of the day. A 2 or 3 legged attempt to close the gap counts as both a 1Rev and 1PB and is usually a high probability trade.

The second attempt to pullback (b9) is sometimes a 1Rev trade and therefore, it may be advisable to exit some or all of your position on the first push down and re-enter on the first 2L pb (b24).

For new traders, 1PB is usually the best setup to take, if they are willing to not trade on days that do not present a clear 1PB. 

Small range days

Small range days are extremely choppy and usually higher risk since every trade needs to be a scalp. Price action will be hard to read and bars will usually look terrible. In general I avoid trading these days and often take no trades. You need to be an excellent scalper with a high percentage of success to trade these days.

Bars that had a small range the previous day and open with no gap or tiny gap (less than one bar) are candidates for small range days. If the first few two legged moves do not go too far and are made of overlapping bars, there is a good chance it will be small range day.

On days like this, do not expect any move to go much beyond the previous swing point. Counter-trend trades are extremely unproductive since the price is unlikely to move beyond a couple of points off your entry.

Market types and setups

The price action that defines markets can be divided into several types and each type has setups that typically work for it. Trending markets for example, facilitate with trend trades and usually cause reversal setups to fail with high probability. Trading ranges on the other hand, facilitate fading breakouts with high probability.

I divide the market price action into the following categories:

Trend (or elastic trend): There is an obvious trending in the market. Bars in the direction of the trend are small, close strong and there are multiple bars in any given trend-side push. Bars against the trend are fewer, usually larger and if there is more than a single bar, closes are usually weaker.

Hard Trend: This is a kind of trend where there are very few bars in the counter-trend direction. With-trend bars can be large or small, pullbacks are usually just a bar or two. This is a very strong trend.

Soft-trend: Bars are very small both trend-side and counter-trend-side. Very shallow pullbacks and pushes.

Channels: Channels look like Soft-trends but with one big difference. Unlike the trends above, a pullback in a channel often overlaps into the previous signal bar.

Trading Range: There is no discernible trend. Erratic movements usually lasting two or three pushes in one direction followed by pushes in the opposing direction. A move in one direction may or may not reach the other side before reversing, therefore hard to gauge profit target.

Barb Wire: A special kind of Trading range where the price action is confined to a narrow range made of small bars, many of which are dojis

The Open: Markets that have "Regular Trading Hours" have opens and closes for the day and the open of a given day has often behavior that may look entirely unlike the previous day. When the market opens and the first bar begins to form, the market is not in any of the above states yet and is considered to be in the open state. This lasts for about 10 bars or so.

The Setups
Each price action type has its own list of setups. A setup that works very well for hard-trend will fail for a channel and vice-versa. These 30 setups cover every possible large move from any type of price action. If you master these, you can trade any market.

There is a small number of setups per price action type and you can focus on a much smaller set of patterns. Setups marked beta are sustained observations but I'm unsure if they can be traded profitably in all kinds of markets. I may drop them in the future.

Setup List

Setup	Name	Trade type	Price Action Type
GRb1	Gap reversal b1	X -- Beta	Open
ib2	Inside bar b2	X -- Beta	Open
1Fb1	1st failure of b1	X	Open
2Fb1	2nd failure of b1	X	Open
1P	1st pullback	X	Open
1FBO	1st fbo of OR	X	Open
2FBO	2nd fbo of OR	X	Open		G	Gap
1W	1st Wedge of day	X	Open		R	Reversal
1TL	1st close at TL	X	Channel		T	trend
1CBO	1st channel BO	X	Channel		b	bar
1ib	1st inside bar	X	Channel		b1	bar 1
CBP	channel BP	X	Channel		P	pullback
CXT	channel XT	X	Channel		1P	1st Pullback
SD	shallow+deep	X	Channel		S	small/shallow
fL2	failed L2	X -- Beta	Channel		OR	Opening Range
fL2	failed L2	X	Soft Trend		TL	Trend Line
STb	small Trend bar	X	Hard Trend		BO	breakout
Tb1	Trend from b1	X	Hard Trend		BP	breakout+P
2_1tF	2nd 1TF	X	Hard Trend		P	pullback
2SP	2nd shallow P	X	Hard Trend		XT	expanding TRI
1TAIL	1st Tail	X -- Beta	Hard Trend		TRI	Triangle
WP	Wedge pullback	X	Trend		BW	Barb Wire
TLP	P at TL	X	Trend		1TF	one tick failure
W	Wedge Reversal	X Rev	Trend
Rfx2	Reversal+fx2	X Rev	Trend
W1P	W + 1st pullback	X Rev	Trend
FBOFx2	FBO + FX2	X fBO	Trading Range
WFBO, DP	Wedge FBO	X fBO	Trading Range
TRI BP	Triangle BP	X BO	Trading Range
XT	Expanding Triangle	X BO	Trading Range
BWBO	Breakout from BW	X BO	BW

Setups not listed above such 1Rev, A2, BO, etc are obsolete due to various reasons such as being incorporated into the list above, me not using EMA anymore and inconsistent profits.