The strategy that we will be looking at is Gap Trading but we will be showing you the right way to trade gaps. This is a high probability scalping strategy.
First we need to understand that a gap is basically when there is a lack of activity between two price points. This is usually caused by a lack of liquidity between the two price points and is a form of price discovery since the price is moving like this in order to find the new “value area” i.e price at which buyers and sellers are willing to trade with each other.
Another key thing that you need to know is that not all gaps are equal. In fact there is only one type of gap that can be used with this strategy. We only pay attention to stocks that are gapping up or down 3% or more.
Any gap smaller than this should be ignored. These big 3%+ gaps tend to follow through in the direction of the gaps far more often than the smaller gaps. In fact, based on our data, about 78% of gaps of 3% or more will follow through in the direction of the gap.
Now that we have that down. Let’s take a look at this strategy in detail:
Step 1: Create a watchlist of stocks in the pre-market that are gapping up or down by 3% or more.
Step 2: You should further filter this list by focusing only on those that have an Average Daily Volume of more than 750,000 and an Average True Range (ATR) of $1.00 or more. This way you will ensure that you are trading only the stocks that will move.
Step 3: You will be trading on the 1 minute chart so pull that up and try to zero in on the stocks on your list that have the biggest gaps in the pre-market. This way you will get a feel for the action just before that market opens.
Step 4: Once you have settled on 1 or 2 stocks from the list. Just wait for the first minute to pass and then make a note of the high and low of that candle.
Step 5: Remember to only trade in the direction of the gap. So, as you can see in the example below, KBR is gapping up so you would go long on a break above the high of the 1 minute candle.
Step 6: Your stop should be placed at the low of the first 1 minute candle.
Step 7: Your profit target should be based on the size/range of the first 1 minute candle. So if the candle is say $1.50 in range ( taken from the bottom of the candle to the top), then your profit target should be $1.50 from the top of the fist 1 minute candle. Does it make sense?
Good. Check out the example.