Fading The Gap - Evaluating An Option Trading System

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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 you’re 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. There’s 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 you’ve 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.

Let’s 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 what’s 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 day’s 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 day’s 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 - they’re not absolutes - but they’re 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 aren’t executed during the pre-market period. They’re 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 don’t miss out on potential profits while the stock price is rising.

Eventually there aren’t 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 day’s 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 there’s 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, it’s based on actual data that’s 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 that’s greater than .25 points, for instance, and to sell after a price movement of more than .5 points. A system like this doesn’t 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 don’t 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 doesn’t 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 system.
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