Trading the Morning Gap
Traders who trade the morning gap are known as “beer traders.” Why such a strange name? While others are trading to squeeze a buck, beer traders are done for the day. They’re sitting at the bar, drinking beer and enjoying the rest of the day. Sounds fun, right?
Well, that depends on whether you’re celebrating your success. But if you got whipped right after the opening bell you might just be drowning your sorrows.
There is good news. While trading the morning gap can be a challenge, done correctly it can definitely be profitable.
What is a Morning Gap?
A morning gap is one price of a certain security, i.e. a stock, an index, a commodity or a specific currency pair. That security will open the trading day at a price possibly much higher or lower than the previous closing price. Why? Because of something that happened overnight or over the weekend. In other words, an event occurred outside the “normal” trading hours.
Say a certain company releases its earnings statement after Wall Street closes (at 4:30 pm). We learn that earnings were dramatically higher than previously thought. Then the next morning, the stock would open several percentage points higher. If you had opened a buy position before the market closed you would have awoken to a nice juicy profit.
Another classic example would be in Oil. Let’s say that over the weekend a war erupted in the Middle East (perish the thought!). Oil is likely to open the trading week significantly higher than its previous closing price.
Filter Out the Right Gaps
When you’re trading the morning gap, you’re essentially walking into “no man’s land.” It’s a place where there is no liquidity and no trading. Right off the start, the odds are risky so you don’t want to be a cowboy. You need to filter out the right gaps to trade, otherwise you’ll be at the bar crying into your beer.
Let’s look further at those two examples. Both can create the same effect yet one is predictable while the other is not. Can you calculate the odds of a stock opening way higher if there are earnings after trade? Actually, you can. Can you gauge the likelihood of a war starting during the weekend?
In the case of the latter, don’t even bother trying to guess. I doubt even those in the middle of fight really know the answer. The fact is there are too many variables and it will never pay off.
In the case of the former, if you know earnings will be reported in the off hours you can predict a gap. Let’s say that the consensus is overwhelmingly grim on a stock. Then the odds for a positive surprise are higher than if the market is more or less even.
Let’s look at XRS stock. You don’t know anything about the company; not what it does or how it does it. But you know what? Who cares? You’re a trader, not an investor. What you should care about is that everyone is bearish and expectations are rock bottom. Thus, you can open a long position before trading is closed.
If the earnings report beats expectations, voilà! You get a morning gap. All you need to do is sit back and wait for the market to open. With the stock now significantly higher you’ll need to close it as quickly as you can. Then you grab your profits and go enjoy your beer.
The key here is to identify known events that are due outside of trading hours. Then, see how the market is positioned ahead of those events. If no one expects a surprise then a gap is more likely and worth a trade. If the market is divided or moved in advance, there’s no juice here.
The Pros and Cons
Pros: If you get it right you can earn a lot of money in a short time span. Open a trade before the markets’ close and close your position first thing in the morning. There’s no need to watch charts for hours at a time. It’s an “easy” buck, comparatively.
Cons: The morning gap can be risky for an average trader. Naturally, they can be unpredictable or at least less predictable than the average trend. The biggest risk is that since it’s outside of market hours, your stop loss and limit orders won’t work. This means that you can potentially lose much more from a gap going against you.