Trading Strategies
John Murphy is a very popular author, columnist, and speaker on the subject of
Technical Analysis. StockCharts.com is very glad to include his Ten Laws of
Technical Trading in our educational material. If you find this information useful,
please visit the MurphyMorris web site for additional examples of John's insight.
John Murphy's Ten Laws of Technical Trading
Which way is the market moving? How far up or down will it go? And when will it go
the other way? These are the basic concerns of the technical analyst. Behind the
charts and graphs and mathematical formulas used to analyze market trends are
some basic concepts that apply to most of the theories employed by today's
technical analysts.
John Murphy, a leader in technical analysis of futures markets, has drawn upon his
thirty years of experience in the field to develop ten basic laws of technical trading:
rules that are designed to help explain the whole idea of technical trading for the
beginner and to streamline the trading methodology for the more experienced
practitioner. These precepts define the key tools of technical analysis and how to
use them to identify buying and selling opportunities.
Mr. Murphy was the technical analyst for CNBC-TV for seven years on the popular
show "Tech Talk" and has authored three best-selling books on the subject --
Technical Analysis of the Financial Markets, Intermarket Technical Analysis
and The Visual Investor.
His most recent book demonstrates the essential "visual" elements of technical
analysis. The fundamentals of Mr. Murphy's approach to technical analysis illustrate
that it is more important to determine where a market is going (up or down) rather
than the why behind it.
The following are Mr. Murphy's ten most important rules of technical trading:
1. Map the Trends
2. Spot the Trend and Go With It
3. Find the Low and High of It
4. Know How Far to Backtrack
5. Draw the Line
6. Follow That Average
7. Learn the Turns
8. Know the Warning Signs
9. Trend or Not a Trend?
10. Know the Confirming Signs
1. Map the Trends
Study long-term charts. Begin a chart analysis with monthly and weekly charts
spanning several years. A larger scale "map of the market" provides more visibility
and a better long-term perspective on a market. Once the long-term has been
established, then consult daily and intra-day charts. A short-term market view
alone can often be deceptive. Even if you only trade the very short term, you will
do better if you're trading in the same direction as the intermediate and longer
term trends.
2. Spot the Trend and Go With It
Determine the trend and follow it. Market trends come in many sizes -- long-term,
intermediate-term and short-term. First, determine which one you're going to trade
and use the appropriate chart. Make sure you trade in the direction of that trend.
Buy dips if the trend is up. Sell rallies if the trend is down. If you're trading the
intermediate trend, use daily and weekly charts. If you're day trading, use daily and
intra-day charts. But in each case, let the longer range chart determine the trend,
and then use the shorter term chart for timing.
3. Find the Low and High of It
Find support and resistance levels. The best place to buy a market is near support
levels. That support is usually a previous reaction low. The best place to sell a
market is near resistance levels. Resistance is usually a previous peak. After a
resistance peak has been broken, it will usually provide support on subsequent
pullbacks. In other words, the old "high" becomes the new "low." In the same way,
when a support level has been broken, it will usually produce selling on subsequent
rallies -- the old "low" can become the new "high."
4. Know How Far to Backtrack
Measure percentage retracements. Market corrections up or down usually retrace a
significant portion of the previous trend. You can measure the corrections in an
existing trend in simple percentages. A fifty percent retracement of a prior trend is
most common. A minimum retracement is usually one-third of the prior trend. The
maximum retracement is usually two-thirds. Fibonacci retracements of 38% and
62% are also worth watching. During a pullback in an uptrend, therefore, initial buy
points are in the 33-38% retracement area.
5. Draw the Line
Draw trend lines. Trend lines are one of the simplest and most effective charting
tools. All you need is a straight edge and two points on the chart. Up trend lines are
drawn along two successive lows. Down trend lines are drawn along two successive
peaks. Prices will often pull back to trend lines before resuming their trend. The
breaking of trend lines usually signals a change in trend. A valid trend line should
be touched at least three times. The longer a trend line has been in effect, and the
more times it has been tested, the more important it becomes.
6. Follow that Average
Follow moving averages. Moving averages provide objective buy and sell signals.
They tell you if existing trend is still in motion and help confirm a trend change.
Moving averages do not tell you in advance, however, that a trend change is
imminent. A combination chart of two moving averages is the most popular way of
finding trading signals. Some popular futures combinations are 4- and 9-day
moving averages, 9- and 18-day, 5- and 20-day. Signals are given when the
shorter average line crosses the longer. Price crossings above and below a 40-day
moving average also provide good trading signals. Since moving average chart lines
are trend-following indicators, they work best in a trending market.
7. Learn the Turns
Track oscillators. Oscillators help identify overbought and oversold markets. While
moving averages offer confirmation of a market trend change, oscillators often help
warn us in advance that a market has rallied or fallen too far and will soon turn.
Two of the most popular are the Relative Strength Index (RSI) and Stochastics.
They both work on a scale of 0 to 100. With the RSI, readings over 70 are
overbought while readings below 30 are oversold. The overbought and oversold
values for Stochastics are 80 and 20. Most traders use 14-days or weeks for
stochastics and either 9 or 14 days or weeks for RSI. Oscillator divergences often
warn of market turns. These tools work best in a trading market range. Weekly
signals can be used as filters on daily signals. Daily signals can be used as filters for
intra-day charts.
8. Know the Warning Signs
Trade MACD. The Moving Average Convergence Divergence (MACD) indicator
(developed by Gerald Appel) combines a moving average crossover system with the
overbought/oversold elements of an oscillator. A buy signal occurs when the faster
line crosses above the slower and both lines are below zero. A sell signal takes
place when the faster line crosses below the slower from above the zero line.
Weekly signals take precedence over daily signals. An MACD histogram plots the
difference between the two lines and gives even earlier warnings of trend changes.
It's called a "histogram" because vertical bars are used to show the difference
between the two lines on the chart.
9. Trend or Not a Trend
Use ADX. The Average Directional Movement Index (ADX) line helps determine
whether a market is in a trending or a trading phase. It measures the degree of
trend or direction in the market. A rising ADX line suggests the presence of a strong
trend. A falling ADX line suggests the presence of a trading market and the absence
of a trend. A rising ADX line favors moving averages; a falling ADX favors
oscillators. By plotting the direction of the ADX line, the trader is able to determine
which trading style and which set of indicators are most suitable for the current
market environment.
10. Know the Confirming Signs
Include volume and open interest. Volume and open interest are important
confirming indicators in futures markets. Volume precedes price. It's important to
ensure that heavier volume is taking place in the direction of the prevailing trend.
In an uptrend, heavier volume should be seen on up days. Rising open interest
confirms that new money is supporting the prevailing trend. Declining open interest
is often a warning that the trend is near completion. A solid price uptrend should be
accompanied by rising volume and rising open interest.
"11."
Technical analysis is a skill that improves with experience and study. Always be a
student and keep learning.
Richard Rhodes' Trading Rules
I must admit, I am not smart enough to have devised these ridiculously simple
trading rules. A great trader gave them to me some 15 years ago. However, I will
tell you, they work. If you follow these rules, breaking them as infrequently as
possible, you will make money year in and year out, some years better than others,
some years worse - but you will make money. The rules are simple. Adherence to
the rules is difficult.
"Old Rules...but Very Good Rules"
If I've learned anything in my 17 years of trading, I've learned that the simple
methods work best. Those who need to rely upon complex stochastics, linear
weighted moving averages, smoothing techniques, fibonacci numbers etc., usually
find that they have so many things rolling around in their heads that they cannot
make a rational decision. One technique says buy; another says sell. Another says
sit tight while another says add to the trade. It sounds like a cliché, but simple
methods work best.
1. The first and most important rule is - in bull markets, one is supposed to be
long. This may sound obvious, but how many of us have sold the first rally
in every bull market, saying that the market has moved too far, too fast. I
have before, and I suspect I'll do it again at some point in the future. Thus,
we've not enjoyed the profits that should have accrued to us for our initial
bullish outlook, but have actually lost money while being short. In a bull
market, one can only be long or on the sidelines. Remember, not having a
position is a position.
2. Buy that which is showing strength - sell that which is showing weakness.
The public continues to buy when prices have fallen. The professional buys
because prices have rallied. This difference may not sound logical, but
buying strength works. The rule of survival is not to "buy low, sell high", but
to "buy higher and sell higher". Furthermore, when comparing various
stocks within a group, buy only the strongest and sell the weakest.
3. When putting on a trade, enter it as if it has the potential to be the biggest
trade of the year. Don't enter a trade until it has been well thought out, a
campaign has been devised for adding to the trade, and contingency plans
set for exiting the trade.
4. On minor corrections against the major trend, add to trades. In bull
markets, add to the trade on minor corrections back into support levels. In
bear markets, add on corrections into resistance. Use the 33-50%
corrections level of the previous movement or the proper moving average as
a first point in which to add.
5. Be patient. If a trade is missed, wait for a correction to occur before putting
the trade on.
6. Be patient. Once a trade is put on, allow it time to develop and give it time
to create the profits you expected.
7. Be patient. The old adage that "you never go broke taking a profit" is maybe
the most worthless piece of advice ever given. Taking small profits is the
surest way to ultimate loss I can think of, for sma ll profits are never allowed
to develop into enormous profits. The real money in trading is made from
the one, two or three large trades that develop each year. You must develop
the ability to patiently stay with winning trades to allow them to develop into
that sort of trade.
8. Be patient. Once a trade is put on, give it time to work; give it time to
insulate itself from random noise; give it time for others to see the merit of
what you saw earlier than they.
9. Be impatient. As always, small loses and quick losses are the best losses. It
is not the loss of money that is important. Rather, it is the mental capital
that is used up when you sit with a losing trade that is important.
10. Never, ever under any condition, add to a losing trade, or "average" into a
position. If you are buying, then each new buy price must be higher than
the previous buy price. If you are selling, then each new selling price must
be lower. This rule is to be adhered to without question.
11. Do more of what is working for you, and less of what's not. Each day, look
at the various positions you are holding, and try to add to the trade that has
the most profit while subtracting from that trade that is either unprofitable
or is showing the smallest profit. This is the basis of the old adage, "let your
profits run."
12. Don't trade until the technicals and the fundamentals both agree. This rule
makes pure technicians cringe. I don't care! I will not trade until I am sure
that the simple technical rules I follow, and my fundamental analyses, are
running in tandem. Then I can act with authority, and with certainty, and
patiently sit tight.
13. When sharp losses in equity are experienced, take time off. Close all trades
and stop trading for several days. The mind can play games with itself
following sharp, quick losses. The urge "to get the money back" is extreme,
and should not be given in to.
14. When trading well, trade somewhat larger. We all experience those
incredible periods of time when all of our trades are profitable. When that
happens, trade aggressively and trade larger. We must make our proverbial
"hay" when the sun does shine.
15. When adding to a trade, add only 1/4 to 1/2 as much as currently held. That
is, if you are holding 400 shares of a stock, at the next point at which to
add, add no more than 100 or 200 shares. That moves the average price of
your holdings less than half of the distance moved, thus allowing you to sit
through 50% corrections without touching your average price.
16. Think like a guerrilla warrior. We wish to fight on the side of the market that
is winning, not wasting our time and capital on futile efforts to gain fame by
buying the lows or selling the highs of some market movement. Our duty is
to earn profits by fighting alongside the winning forces. If neither side is
winning, then we don't need to fight at all.
17. Markets form their tops in violence; markets form their lows in quiet
conditions.
18. The final 10% of the time of a bull run will usually encompass 50%
or more of the price movement. Thus, the first 50% of the price
movement will take 90% of the time and will require the most
backing and filling and will be far more difficult to trade than the last 50%.
There is no "genius" in these rules. They are common sense and nothing else, but
as Voltaire said, "Common sense is uncommon." Trading is a common-sense
business. When we trade contrary to common sense, we will lose. Perhaps not
always, but enormously and eventually. Trade simply. Avoid complex
methodologies concerning obscure technical systems and trade according to the
major trends only.
The "Last" Stochastic Technique
The Stochastic oscillator is a momentum or price velocity indicator developed by
George Lane. The calculation is very simple:
Where:
K = Lane's Stochastic
C = latest closing price
L = then-period low price
H = the n-period high price
Additionally, Lane's methods specifically required that the K be smoothed twice with
three-period simple moving averages. Two other calculations are then made:
SK = three period simple moving average of K
SD = three period simple moving average of SK
The classic interpretation of a stochastic can be complicated. The basic method is to
buy when the SK is above the SD, and sell when the SK moves below the SD.
However, the stochastic employs a fixed period-to-period calculation that can move
about erratically as the earliest data point is dropped for the next day's calculation.
Due to this instability and false signals generated, using a stochastic for entry and
exit signals can incur a lot of unprofitable trades. To compensate for this inherent
weakness, buy signals are generally reinforced when the crossover occurs in the
10-15% ranges, and sells in the 85-90% ra nge.
Unfortunately, many techniques for using the stochastic oscillator can produce
consistent losses over time. Some analysts have recommended smoothing the data
further, or looking for a confirming overbought/oversold ratio prior to selling or
buying. Most secondary filters such as overbought/oversold indicators degrade the
performance of the stochastic in that one does not take advantage of major trends,
getting whipsawed in and out.
K39 - The Last Stochastic Technique
A study published in "The Encyclopedia of Technical Market Indicators" found that
some very good signals were given by an unsmoothed 39 period stochastic
oscillator (K = 39, no signal line). A buy signal is generated when K crosses above
50% and the closing price is above the previous week's high close. Sell and/or sell
short signals are created when the K line crosses below 50% and the closing price
is below the previous week's low close. Taking a longer period, and not smoothing
the data over a 3-period moving average allows the analyst to view Lane's
Stochastic.
Note: You can add the Last Stochastic to our SharpChart charting tool by adding
the "Slow Stochastic" indicator with parameters of 39 and 1. Here is an example.
Alternately, you can click on the link labelled "Scott McCormick's recommended
settings for mutual funds" which is located below the chart.
In the chart below for MSFT, we see that the 39 period K crossed above 50% on
June 14, at around $72.00.
Weekly, Daily and Hourly through Minute data can all be used effectively for the 39
period stochastic. Using weekly data for three years, we see that the 39-Week
Stochastic for MSFT didn't cross below 50% until late February, 2000.
The whipsaw that occured for MSFT the following month shows the need for signal
confirmation. If we look at CSCO for the last year on daily data, we see that by the
39 day stochastic, it was a hold from November 1999 at $35 through early April
2000 at $65 a share. Here again, we see a false rally at the end of April. What can
be used for confirmation?
Confirmation
Since the Stochastic is a price momentum indicator, one should pair it with a
volume assessment for trade confirmation. In the chart below, the On Balance
Volume (OBV) indicator has been added along with a 30 day MA as a signal line.
Current version of this chart.
Notice that there was a bullish OBV crossover in early November 1999 and again in
early June 2000 soon after the K line moved back above 50%. Although the Last
Stochastic reversed in April, the OBV crossover did not occur. When the K line
moved above 50% again in early June, confirmation soon followed.
One last point to remember is that all stocks are unique, and while the 39 period
Stochastic is a useful technical indicator, one should always map the performance
against your specific stock. Recently, most Tech stocks have evidenced a tendency
to signal entry at a K crossover above 40% and a sell with K crossing below 60%.
However, in volatile equities a second price or sentiment indicator along with a
volume indicator provides the best confirmation.
Arthur Hill On Goals, Style and Strategy
Before investing or trading, it is important to develop a strategy or game plan that
is consistent with your goals and style. The ultimate goal is to make money (win),
but there are many different methods to go about it.
As with many aspects of trading, many sports offer a good analogy. A football team
with goals geared towards ball control and low-scoring games might adapt a
conservative style that focuses on the run. Teams that want to score often and
score quickly are more likely to pursue an aggressive style geared towards passing.
Teams are usually aware of their goal and style before they develop a game plan.
Investors and traders can also benefit by keeping in mind their goals and style
when developing a strategy.
Goals
First and foremost are goals. The first set of questions regarding goals should
center on risk and return. One cannot consider return without weighing risk. It is
akin to counting your chickens before they are hatched. Risk and return are highly
correlated. The higher the potential return, the higher the potential risk. At one end
of the spectrum are US Treasury bonds, which offer the lowest risk (so-called risk
free rate) and a guaranteed return. For stocks, the highest potential returns (and
risk) center around growth industries with stock prices that exhibit high volatility
and high price multiples (PE, Price/Sales, Price/Hope). The lowest potential returns
(and risk) come from stocks in mature industries with stock prices that exhibit
relatively low volatility and low price multiples.
Style
After your goals have been established, it is time to develop or choose a style that
is consistent with achieving those goals. The expected return and desired risk will
affect your trading or investing style. If your goal is income and safety, buying or
selling at extreme levels (overbought/oversold) is an unlikely style. If your goals
center on quick profits, high returns and high risk, then bottom picking strategies
and gap trading may be your style.
Styles range from aggressive day traders looking to scalp 1/4-1/2 point gains to
investors looking to capitalize on long-term macro economic trends. In between,
there are a whole host of possible combinations including swing traders, position
traders, aggressive growth investors, value investors and contrarians. Swing
traders might look for 1-5 day trades, position traders for 1-8 week trades and
value investors for 1-2 year trades.
Not only will your style depend on your goals, but also on your level of
commitment. Day traders are likely to pursue an aggressive style with high activity
levels. The goals would be focused on quick trades, small profits and very tight
stop-loss levels. Intraday charts would be used to provide timely entry and exit
points. A high level of commitment, focus and energy would be required.
On the other hand, position traders are likely to use daily end-of-day charts and
pursue 1-8 week price movements. The goal would be focused on short to
intermediate price movements and the level of commitment, while still substantial,
would be less than a day trader. Make sure your level of commitment jibes with
your trading style. The more trading involved, the higher the level of commitment.
Strategy
Once the goals have been set and preferred style adopted, it is time to develop a
strategy. This strategy would be based on your return/risk preferences,
trading/investing style and commitment level. Because there are many potential
trading and investing strategies, I am going to focus on one hypothetical strategy
as an example.
GOAL: First, the goal would be a 20-30% annual return. This is quite high and
would involve a correspondingly high level of risk. Because of the associated risk, I
would only allot a small percentage (5-10%) of my portfolio to this strategy. The
remaining portion would go towards a more conservative approach.
STYLE: Although I like to follow the market throughout the day, I cannot make the
commitment to day trading and use of intraday charts. I would pursue a position
trading style and look for 1-8 week price movements based on end-of-day charts.
Indicators will be limited to three with price action (candlesticks) and chart patterns
will carry the most influence.
Part of this style would involve a strict money management scheme that would limit
losses by imposing a stop-loss immediately after a trade is initiated. An exit
strategy must be in place before the trade is initiated. Should the trade become a
winner, the exit strategy would be revised to lock in gains. The maximum allowed
per trade would be 5% of my total trading capital. If my total portfolio were
300,000, then I might allocate 21,000 (7%) to the trading portfolio. Of this 21,000,
the maximum allowed per trade would be 1050 (21,000 * 5%).
STRATEGY: The trading strategy is to go long stocks that are near support levels
and short stocks near resistance levels. To maintain prudence, I would only seek
long positions in stocks with weekly (long-term) bull trends and short positions in
stocks with weekly (long-term) bear trends. In addition, I would look for stocks that
are starting to show positive (or negative) divergences in key momentum indicators
as well as signs of accumulation (or distribution). My indicator arsenal would consist
of two momentum indicators (PPO and Slow Stochastic Oscillator) and one volume
indicator (Accumulation/Distribution Line). Even though the PPO and the Slow
Stochastic Oscillator are momentum oscillators, one is geared towards the direction
of momentum (PPO) and the other towards identifying overbought and oversold
levels (Slow Stochastic Oscillator). As triggers, I would use key candlestick
patterns, price reversals and gaps to enter a trade.
This is just one hypothetical strategy that combines goals with style and
commitment. Some people have different portfolios that represent different goals,
styles and strategies. While this can become confusing and quite time consuming,
separate portfolios ensure that investment activities pursue a different strategy
than trading activities. For instance, you may pursue an aggressive (high-risk)
strategy for trading with a small portion of your portfolio and a relatively
conservative (capital preservation) strategy for investing with the bulk of your
portfolio. If a small percentage (~5-10%) is earmarked for trading and the bulk
(~90-95%) for investing, the equity swings should be lower and the emotional
strains less. However, if too much of a portfolio (~50-60%) is at risk through
aggressive trading, the equity swings and the emotional strain could be large.
Arthur Hill On Moving Average Crossovers
A popular use for moving averages is to develop simple trading systems based on
moving average crossovers. A trading system using two moving averages would
give a buy signal when the shorter (faster) moving average advances above the
longer (slower) moving average. A sell signal would be given when the shorter
moving average crosses below the longer moving average. The speed of the
systems and the number of signals generated will depend on the length of the
moving averages. Shorter moving average systems will be faster, generate more
signals and be nimble for early entry. However, they will also generate more false
signals than systems with longer moving averages.
XIRC
For Xircom, a 30/100 exponential moving average crossover was used to generate
signals. When the 30-day EMA moves above the 100-day EMA, a buy signal is in
force. When the 30-day EMA declines below the 100-day EMA, a sell signal is in
force. A plot of the 30/100 differential is shown below the price chart by using the
Percentage Price Oscillator (PPO) set to (30,100,1). When the differential is
positive, the 30-day EMA is greater than the 100-day EMA. When it is negative, the
30-day EMA is less than the 100-day EMA.
As with all trend-following systems, the signals work well when the stock develops
a strong trend, but are ineffective when the stock is in a trading range. Some good
entry points for long positions were caught in Sept-97, Mar-98 and Jul-99.
However, an exit strategy based on the moving average crossover would have
given back some of those profits. All in all, though, the system would have been
profitable for the time period shown.
3COM
In the example for 3Com, a 20/60 EMA crossover system was used to generate buy
and sell signals. The plot below the price is the 20/60 EMA differential, which is
shown as a percent and displayed using the Percentage Price Oscillator (PPO) set at
(20,60,1). The thin blue lines just above and below zero (the centerline) represent
the buy and sell trigger points. Using zero as the crossover point for the buy and
sell signals generated too many false signals. Therefore, the buy signal was set just
above the zero line (at +2%) and the sell signal was set just below the zero line (at
-2%). When the 20-day EMA is more than 2% above the 60-day EMA, a buy signal
is in force. When the 20-day EMA is more than 2% below the 60-day EMA, a sell
signal is in force.
There were a few good signals, but also a number of whipsaws. Although much
would depend on the exact entry and exit points, I believe that a profit could have
been made using this system, but not a large profit and probably not enough to
justify the risk. The stock failed to hold a trend and tight stop-losses would have
been required to lock in profits. A trailing stop or use of the parabolic SAR might
have helped lock in profits.
Moving average crossover systems can be effective, but should be used in
conjunction with other aspects of technical analysis (patterns, candlesticks,
momentum, volume, and so on). While it is easy to find a system that worked well
in the past, there is no guarantee that it will work in the future.
Gap Trading Strategies
Gap trading is a simple and disciplined approach to buying and shorting stocks.
Essentially one finds stocks that have a price gap from the previous close and
watches the first hour of trading to identify the trading range. Rising above that
range signals a buy, and falling below it signals a short.
What is a Gap?
A gap is a change in price levels between the close and open of two consecutive
days. Although most technical analysis manuals define the four types of gap
patterns as Common, Breakaway, Continuation and Exhaustion, those labels are
applied after the chart pattern is established. That is, the difference between any
one type of gap from another is only distinguishable after the stock continues up or
down in some fashion. Although those classifications are useful for a longer-term
understanding of how a particular stock or sector reacts, they offer little guidance
for trading.
For trading purposes, we define four basic types of gaps as follows:
A Full Gap Up occurs when the opening price is greater than yesterday's high
price.
In the chart below for Cisco, the open price for June 2, indicated by the small tick
mark to the left of the second bar in June (green arrow), is higher than the
previous day's close, shown by the right-side tick mark on the June 1 bar.
A Full Gap Down occurs when the opening price is less than yesterday's low.
The chart for Lycos, below, shows both a full gap up on May 16 (green arrow) and a
full gap down the next day (red arrow).
A Partial Gap Up occurs when today's opening price is higher than yesterday's
close, but not higher than yesterday's high.
The next chart for Earthlink depicts the partial gap up on June 1 (red arrow), and
the full gap up on June 2 (green arrow).
A Partial Gap Down occurs when the opening price is below yesterday's close, but
not below yesterday's low.
The red arrow on the chart for Offshore Logistics, below, shows where the stock
opened below the previous close, but not below the previous low.
For the bulk of this tutorial, intraday charts of 2, 5 or 10 days will be used to
demonstrate entry and exit signals for long and short positions. Notice that the
intraday chart (below) is graphed slightly differently, showing a composite of the
trades occurring every 15 minutes. Although a trade-by-trade intraday charting tool
would show the exact bid and ask spread, this tutorial will refer to the left-side
horizontal line of each bar as the open, and the right side horizontal bar as the
close of each trade.
The beige vertical double lines represent day-to-day breaks, and the single beige
vertical lines represent one or two hour divisions. Reference the time scale at the
bottom of each chart.
Why Use Trading Rules?
In order to successfully trade gapping stocks, one should use a disciplined set of
entry and exit rules to signal trades and minimize risk. Additionally, gap trading
strategies can be applied to weekly, end-of-day, or intraday gaps. It is important
for longer-term investors to understand the mechanics of gaps, as the 'short'
signals can be used as the exit signal to sell holdings.
The Gap Trading Strategies
Each of the four gap types has a long and short trading signal, defining the eight
gap trading strategies. The basic tenet of gap trading is to allow one hour after the
market opens for the stock price to establish its range. A Modified Trading Method,
to be discussed later, can be used with any of the eight primary strategies to
trigger trades before the first hour, although it involves more risk. Once a position
is entered, you calculate and set an 8% trailing stop to exit a long position, and a
4% trailing stop to exit a short position. A trailing stop is simply an exit threshold
that follows the rising price or falling price in the case of short positions.
Long Example: You buy a stock at $100. You set the exit at no more than 8%
below that, or $92. If the price rises to $120, you raise the stop to $110.375, which
is approximately 8% below $120. The stop keeps rising as long as the stock price
rises. In this manner, you follow the rise in stock price with either a real or mental
stop that is executed when the price trend finally reverses.
Short Example: You short a stock at $100. You set the Buy-to-Cover at $104 so
that a trend reversal of 4% would force you to exit the position. If the price drops
to $90, you recalculate the stop at 4% above that number, or $93 to Buy-to-Cover.
The eight primary strategies are as follows:
Full Gap Up: Long
If a stock's opening price is greater than yesterday's high, revisit the 1-minute
chart after 10:30 am and set a long (buy) stop two ticks above the high achieved in
the first hour of trading. (Note: A 'tick' is defined as the bid/ask spread, usually 1/8
to 1/4 point, depending on the stock.)
In the case of CMGI below, the stock gapped open on a Tuesday morning and
opened at $46.25. The high reached in the first hour of trading on the day of the
gap was $47.50. A buy stop at $47.75, or two 1/8 ticks above the high, would have
been triggered shortly before 11:00 am that day. CMGI closed at $51.75 that day,
for a $4.00 (8.4%) gain.
An 8% protective sell stop is roughly $44 on the day you entered, and over the
next five days rises to $53.875 (which is 8% below the final close of $58.50). At
this point, even if the sell stop is triggered, you are up over $6, or 12.5%. At this
level of price growth, however, one would normally reduce the sell stop to 5% or
less to protect profit.
The chart below for AKAM shows that the high of $83.5 was reached by 10:30 am,
and a buy signal was generated when that price was broken around 2:15 PM. An
entry of $84 would have profited $3 by the close, and the trailing stop would be set
at $80 (8% less than the $87 close).
Full Gap Up: Short
If the stock gaps up, but there is insufficient buying pressure to sustain the rise,
the stock price will level or drop below the opening gap price. Traders can set
similar entry signals for short positions as follows:
If a stock's opening price is greater than yesterday's high, revisit the 1-minute
chart after 10:30 am and set a short stop equal to two ticks below the low achieved
in the first hour of trading.
In the case of General Electric, it gapped open, and established a low of $53.25 in
the first hour of trading. This support level was broken before 11:00 am and would
have signaled a short entry at $53. A trailing stop of 4% would set a Buy to Cover
limit of $55.125.
Full Gap Down: Long
Poor earnings, bad news, organizational changes and market influences can cause a
stock's price to drop uncharacteristically. A full gap down occurs when the price is
below not only the previous day's close, but the low of the day before as well. A
stock whose price opens in a full gap down, then begins to climb immediately, is
known as a "Dead Cat Bounce."
If a stock's opening price is less than yesterday's low, set a long stop equal to two
ticks more than yesterday's low.
The Time Warner Telecom chart shows a full gap down 6 days ago at $42, below
the previous day's low at $42.50. An entry signal for a long position was signaled
with a gap at open to $48, well above the $43 buy stop. This chart illustrates why
an immediate entry may be taken at open as long as it has been preceded by an
another gap signal. An 8% trailing stop after entry would never have forced an exit,
and this trade would be up over 40% in one week.
Full Gap Down: Short
If a stock's opening price is less than yesterday's low, revisit the 1-minute chart
after 10:30 am and set a short stop equal to two ticks below the low achieved in
the first hour of trading.
The signal to short General Motors occurs the day after the major gap down at $76.
Although a 4% trailing stop would be calculated at $79, the large volume spikes at
close and open during the last two days of the chart would reasonably suggest
accumulation and that it was time to buy to cover.
Partial Gaps
The difference between a Full and Partial Gap is risk and potential gain. In general,
a stock gapping completely above the previous day's high has a significant change
in the market's desire to own or sell it. Demand is large enough to force the market
make r or floor specialist to make a major price change to accommodate the unfilled
orders. Full gapping stocks generally trend farther in one direction than stocks
which only partially gap. However, a smaller demand may just require the trading
floor to only move price above or below the previous close in order to trigger
buying or selling to fill on-hand orders. There is a generally a greater opportunity
for gain over several days in full gapping stocks.
If there is not enough interest in selling or buying a stock after the initial orders are
filled, the stock will return to its trading range quickly. Entering a trade for a
partially gapping stock generally calls for either greater attention or closer trailing
stops of 5-6%.
Partial Gap Up: Long
If a stock's opening price is greater than yesterday's close, but not greater than
yesterday's high, the condition is considered a Partial Gap Up. The process for a
long entry is the same for Full Gaps in that one revisits the 1-minute chart after
10:30 am and set a long (buy) stop two ticks above the high achieved in the first
hour of trading.
Parametric Technologies chart gapped above the previous close and broke through
the first hour's high around noon. The following three days provided a substantial
return.
Starbucks similarly provided a partial gap up and broke through by noon on the day
of the gap. It also climbed significantly for the following three days.
Partial Gap Up: Short
The short trade process for a partial gap up is the same for Full Gaps in that one
revisits the 1-minute chart after 10:30 am and sets a short stop two ticks below the
low achieved in the first hour of trading.
Perot System's open on the second of the two-day chart below is above the close
but not above the high of the previous day. The low by 10:30 am was 15.625,
broken at 11:30 am and triggering a short.
Partial Gap Down: Long
If a stock's opening price is less than yesterday's close, revisit the 1 minute chart
after 10:30 am and set a buy stop two ticks above the high achieved in the first
hour of trading.
Rudolph Technologies closed at $27.50 and opened at $26.5 the following day. The
high by 10:30 am was $30, and that was penetrated just before 11:00 am. A limit
buy entry was signaled at $30.25 and the stock closed at $32.
Partial Gap Down: Short
The short trade process for a partial gap down is the same for Full Gap Down in
that one revisits the 1-minute chart after 10:30AM and sets a short stop two ticks
below the low achieved in the first hour of trading.
If a stock's opening price is less than yesterday's close, set a short stop equal to
two ticks less than the low achieved in the first hour of trading today.
Digital Insight closed at $47 and opened as a partial gap down at $46 the following
morning. The low by 10:30 am was $45 providing a $44.50 short signal. DGIN sank
from that entry and closed $1 lower.
If the volume requirement is not met, the safest way to play a partial gap is to wait
until the price breaks the previous high (on a long trade) or low (on a short trade).
End-of-day Gap Trading
All eight of the Gap Trading Strategies can be applied to end-of-day trading. One
can use either intraday charts, such as the example for INIT below, or daily data
charts like the DeBeers chart (DBRSY) further down. The trading strategy to be
used should be obvious by now.
Using StockCharts.com's Gap Scans, end-of-day traders can review those stocks
with the best potential. Increases in volume for stocks gapping up or down is a
strong indication of continued movement in the same direction of the gap. A
gapping stock that crosses above resistance levels provides reliable entry signals.
Similarly, a short position would be signalled by a stock whose gap down fails
support levels.
What is the Modified Trading Method?
The Modified Trading Method applies to all eight Full and Partial Gap scenarios
above. The only difference is instead of waiting until the price breaks above the
high (or below the low for a short); you enter the trade in the middle of the
rebound. The other requirement for this method is that the stock should be trading
on at least twice the average volume for the last five days. This method is only
recommended for those individuals who are proficient with the eight strategies
above, and have fast trade execution systems. Since heavy volume trading can
experience quick reversals, mental stops are usually used instead of hard stops.
Modified Trading Method: Long
If a stock's opening price is greater than yesterday's high, revisit the 1 minute
chart after 10:30 am and set a long stop equal to the average of the open price and
the high price achieved in the first hour of trading. This method recommends that
the projected daily volume be double the 5-day average.
Modified Trading Method: Short
If a stock's opening price is less than yesterday's low, revisit the 1 minute chart
after 10:30 am and set a long stop equal to the average of the open and low price
achieved in the first hour of trading. This method recommends that the projected
daily volume be double the 5-day average.
Where do I find gapping stocks?
StockCharts.com publishes lists of stocks that fully gapped up or fully gapped down
each day based on end-of-day data. This is an excellent source of ideas for longer
term investors.
Intuit Corporation acquired Hutchinson Avenue Software Corporation and
redeployed the Mach6 application as their QuickQuotesLive product. The Market
Trends feature of this application provides timely lists of stocks on all exchanges
with Full and Partial Up and Down Gaps, as well as a PreOpen Gap Up and Gap
Down listing.
ClearStation also provides a list of Stocks gapping up and down for all major US
markets under their Most Actives & Price Movers listing.
Although these are useful lists of gapping stocks, it is important to look at the
longer term charts of the stock to know where the support and resistance may be,
and play only those with an average volume above 500,000 shares a day until the
gap trading technique is mastered. The most profitable gap plays are normally
made on stocks you've followed in the past and are familiar with.
How successful is this?
In simple terms, the Gap Trading Strategies are a rigorously defined trading system
that uses specific criteria to enter and exit. Trailing stops are defined to limit loss
and protect profits. The simplest method for determining your own ability to
successfully trade gaps is to paper trade. Paper trading does not involve any real
transaction. Instead, one writes down or logs an entry signal and then does the
same for an exit signal. Then subtract commissions and slippage to determine your
potential profit or loss.
Gap trading is much simpler than the length of this tutorial may suggest. You will
not find either the tops or bottoms of a stock's price range, but you will be able to
profit in a structured manner and minimize losses by using stops. It is, after all,
more important to be consistently profitable than to continually chase movers or
enter after the crowd.
The Pre-Holiday Effect
Over the past century, there have been nine holidays during which the Exchanges
have traditionally been closed. Historical research shows that stock prices often
behave in a specific manner in each of the two trading days preceding these
holidays. By becoming aware of this behavior, both short-term traders and longer-
term investors can benefit.
The general strategy is to purchase equities one or two days prior to a holiday.
Short-term traders would look to sell just after the holiday while longer-term
investors would wait until year end. Both strategies have proven to be profitable
plays. The theory behind this effect is that traders are lightening up their holdings
(selling) prior to the three day holiday in order to avoid any unexpected bad news.
The selling pressure drives stock prices down, making those days a good
opportunity for buying lower in the range.
Here is the average pre-holiday results for the last 50 years, based on the S&P 500
Index:
Buy two days before, Buy one day before,
Holiday
sell at year end sell at year end
President's Day* -0.1% 12.2%
Good Friday 7.3% 17.8%
Memorial Day -4.7% 22.8%
Independence Day 13.3% 37.3%
Labor Day 16.8% 33.7%
Election Day 17.9% 4.6%
Thanksgiving 4.3% 1.1%
Christmas -7.1% 15.2%
New Year's 31.1% 19.6%
*Note: President's Day data is comprised of the aggregate of both Washington and Lincoln's Birthday prior to
1998.
The original research was based on the behavior of the S&P 500 Index around the
419 holiday market closings that occurred from 1928 to 1975.
To put those returns in perspective, if you had invested $10,000 in the S&P 500
Index in January 1928 and sold it all in December 1975, you would have ended up
with $51,441. However, if you had invested one-ninth of your money just before
each pre-holiday period (selling everything at the end of the year), you would have
finished with $1,440,716. Not bad!
The Short Term Tra ding Strategy
Short term trading using the this pre-holiday effect can provide excellent results. In
the chart for GE, below, we see that a buy near open on June 30th would be
accomplished around $49.25. Selling at open on July 5th at $52.50 provided
excellent returns.
It is important to note that there are two holidays which often have a partial
trading day during the holiday weekend - the day before Independence Day and the
day after Thanksgiving. These days usually have a shorten trading session that can
be extremely volatile. While they can be traded, volume is always very light and it
may be difficult to get limit orders filled.
In the chart below for Motorola (MOT), we can see that a buy at $30 on June 30th
would have been a flat trade July 3rd, but rose $2 and $3 a share in the two days
following the July 4th holiday.
For VOYN, we have a buy near close at $8, and a sell just after the open on July 5th
at $9.5. The volume is less than 100,000 shares on average, and the stock is
generally downtrending, but the method is still viable.
The Long Term Trading Strategy
Again, the theory says that stocks generally fall on those days because traders
offload their holdings in order to avoid the risk of significant news appearing while
the markets are closed. Longer-term investors who are willing to ride out any
short-term negative news are rewarded with lower entry prices.
Here are four examples from the 2000 Memorial Day holiday (May 26th) where
excellent entry points appeared:
Investors that took advantage of those dips should be rewarded by year end.
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