Fading The Gap - Evaluating An Option Trading System
By Ultimate Trading
One Option Trading System That You Will Find Very Effective
Trading can be a risky, high-stakes venture, full of excitement and
tension. And likely a complete failure, if youre using an option
trading system that creates that kind of environment. A good
option trading system is one that enables you to make rational
and logical decisions, not emotional ones, and manages risk
responsibly. Theres always risk in trading, but your option trading
system should allow you to make sure your risk to reward ratio is
favourable on every trade.
Most successful investors develop their own option trading system
because they need a workable formula that suits their own individual
temperaments and needs. What works for one person will not work for
another. But once youve chosen an option trading system that you
feel meets your objectives, you need to decide if it is an effective
system, which can be a difficult task.
Lets look at an example of one type of option trading system to
give you a better sense of what an option trading system is, how one
can work, and how you can evaluate that option trading system. Many
traders do whats sometimes referred to as fading the gap when a
stock market opens for normal trading in the morning.
A gap up is an opening stock price that is significantly higher than
the previous days closing price. For the entire market, a gap up
occurs when the market as a whole opens higher than it closed the
previous day. A gap down is an opening stock price that is
significantly lower than the previous days closing price. For the
entire market, a gap down is when the market as a whole opens lower
than it closed the previous day.
On a gap-up day, the reversal downward to close the gap often ends
at the low of the day, and on a gap-down day, the reversal upward
often ends at the high of the day. Morning gaps are trends - theyre
not absolutes - but theyre a fairly predictable phenomenon within
an option trading system.
Why? Two facts are responsible for the pattern of gaps, followed by
volatility, followed by reversals. The first is pre-market trading
between 8 a.m. and 9.30 a.m. During the pre-market period, only
institutions and other traders with pre-market access can trade, and
their activity can make the price of a stock rise or fall
substantially before the normal market open time.
The second is that anyone with an online trading account following
their own option trading system can place overnight orders between
the time the market closes and reopens the next day. Overnight
orders arent executed during the pre-market period. Theyre held
until the market opens at 9.30 a.m. and many people who place
overnight orders place market orders instead of limit orders, so
they accept whatever price they get.
Because of the
option trading system, the early trading plays out predictably.
If there are more buy orders than sell orders, the market makers
have an incentive to drive up the price in the pre-market period, so
the stock opens with a gap up.
Then the rush of overnight orders drives the price up further
because there are more buyers than sellers. Then, other investors
see the stock price rise and decide they need to jump in so they
dont miss out on potential profits while the stock price is rising.
Eventually there arent any buy orders left to fill. As soon as the
buyers are depleted, the price of the stock drops back down to a
level close to the previous days close. So, the stock opened with a
gap up, then reversed downwards to close the gap.
Smart traders make money in gap situations by following their option
trading system. They buy on a gap down, and they sell short on a gap
up. The technique is known as fading the gap because by trading
against the gap, the traders make the price gap narrow or fade.
Fading the gap means buying near the lowest point in the volatility
after a gap down, with the expectation that the stock price will
bounce back up after all the sellers have been depleted. Or, when
theres a gap up, traders short near the highest point in the
volatility after the gap up, anticipating the price will fall after
all the overnight buy orders have been filled.
So why is fading the gap a potentially effective option trading
system? First, the results are measurable: the trading takes place
within a short period of time, and you can quickly see if your
trades are profitable or not. You can also track them in aggregate
over the long-term, so you can easily analyze the effectiveness of
the option trading system.
Second, its based on actual data thats available to you before the
market opens, so you can apply a mechanical approach to your option
trading system: if you see a gap up or a gap down, you can
automatically trade accordingly. Your option trading system may be
to trade into a gap thats greater than .25 points, for instance,
and to sell after a price movement of more than .5 points. A system
like this doesnt tie up a great deal of capital for long periods of
time. And, you can hedge your risk by applying formulas and
parameters to your trades to protect yourself in case the trades
dont work out as planned.
Remember: Your goal is long-term success, so try for consistent
profits, limit your losses, and make decisions based on reason and
logic, not on emotion. Any
option trading system that doesnt allow you to operate that way
is a poor system for you to use. Fading the gap allows a trader to
do all of these things, making it an effective option trading
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