Q&A
Futures For You
Inside The Futures World
Want to find out how the futures markets really work?
DeCarley Trading senior analyst and broker Carley Garner responds to your questions
about today’s futures markets. To submit a question, post your question
at https://Message-Boards.Traders.com. Answers will be posted there, and selected questions will appear in a future issue of S&C. Visit Garner at www.DeCarleyTrading.com. Her books, Commodity Options and A Trader’s First Book On Commodities, are available from FT Press.
WHAT DO GAP TRADERS WANT?
What exactly are gap traders looking for?
For those unfamiliar with gap trading, a price gap occurs when there is a significant difference in the closing price of the previous session relative to the opening price of the following session. A gap is described by its direction; for instance, you might hear traders refer to a gap with an increase in price as a “gap up” or a “gap higher.” A sharp decrease in price from the previous session close is known as a “gap down” or a “gap lower.”
Price gaps used to be common in commodities due to abbreviated trading sessions relative to equities, and the potential volatility exposure overnight and on weekends. Although this type of price action still occurs in the futures markets today, it is much less common than it once was.
The scarcity of large price gaps can be attributed to the fact that most futures contracts trade virtually 24 hours per day during the week these days. Accordingly, in most cases, there simply isn’t enough time between trading sessions to justify a large price move.
There are exceptions, of course, such as during earnings season. Many corporations report results just after the close of stock index futures at 3:15 Central time but before the reopen of trade at 3:30. On most days, 15 minutes of down time is insignificant, but this is not the case in the midst of earnings announcements periods. If a bellwether firm reports an earnings per share figure other than what is expected, it is possible to see dramatic price gaps on the reopen of trade at 3:30.
Another opportunity for price gaps exists on the reopen of futures trade Sunday afternoon or evening (depending on the contract, exchange, and the part of the country you’re in). From the Friday afternoon close to the Sunday reopen, all markets are closed for trade, but during the two-day hiatus, political events might have developed or a natural disaster could have occurred. As a result, gaps higher or lower from the Friday close are more or less expected or at least seen on a regular basis.
The lessened frequency of price gaps has done wonders for attracting retail traders into commodities. We have all heard the horror stories of markets gapping limit up or down, trapping traders in positions; this is no longer a compelling excuse to avoid commodity trading — although there are certainly other arguments against participating.
Most trading courses and literature will tell you that 80% of gaps are filled. This is probably nearly impossible to confirm, so we will take their word for it. In addition, based on experience, it seems to be a pretty good ballpark figure to work with. If a market fills a gap, it means the price of the futures contract retraced after the gap occurred to the previous day’s closing price (pregap price). Unfortunately, just knowing that most gaps are filled isn’t enough to trade profitably. Like anything else in trading, timing is everything. In some scenarios, a gap is filled immediately or within days, but in other environments it can take weeks or months for the process to complete itself.
A gap is only possible in the event of an overwhelming shift in market sentiment, and therefore, markets that have experienced a gap should be treated with even more respect than is usually the case. That said, gap traders typically look at two speculative prospective strategies once a price gap occurs; the possibility of fading the gap by speculating the market will move in the opposite direction of the gap by filling it or preparing for a position in the direction of the gap once it has been filled.
For instance, in early October 2010, March corn futures gapped 45 cents higher to $5.82½ on the Sunday evening open following a grain report released on the preceding Friday. The previous session closing price was $5.37½. Bearish traders might have opted to sell futures, buy puts, sell calls, or a combination of the three in anticipation of the market trading back to $5.37½ as the gap is filled. Bullish traders might wait for a pullback to $5.37½ to add to longs or initiate a position (buy calls, sell puts, buy futures, or other).
Trading is an art, not a science; traders should look at the gap prices as approximations, not absolutes. Even if the gap is filled and the market later recovers, the low of the move will likely not be $5.37½. In this instance, March corn sold off to make a low at $5.22 (well below the gap price) before resuming the rally. Some might have given up on the trade a little below $5.37½, but keep in mind, gap trading is a relatively simple strategy and likely to have many followers. So if most traders are looking for a certain price to hold, it probably won’t. The temporary dip to $5.22 was probably stop-running to flush out the weak bulls; unfortunately, this is how markets operate.