A Quantitative Approach to Gap Fill Probability for Swing Traders

While the Gap & Go strategy focuses on continuation, a significant number of gaps eventually fill. Understanding the probability of a gap fill can provide a effective edge for swing traders. This article will examine into a quantitative approach to analyzing gap fill probability, helping you to identify when to fade a gap rather than follow it.

Entry Rules

Fading a gap is a contrarian strategy that requires a different set of entry rules:

• Gap Size: We are looking for gaps between 2% and 5%. Gaps larger than 5% are more likely to be driven by significant news and are less likely to fill.
• Volume: The gap should occur on average or below-average volume. High volume indicates strong conviction and makes a gap fill less likely.
• Failed Follow-Through: The stock should fail to make a new high in the first hour of trading. This is a sign of weakness and increases the probability of a gap fill.
• Entry Point: Our entry is a short-sell order placed below the low of the first 30-minute candle.

Exit Rules

Exiting a gap fill trade is all about capturing the move back to the previous day's close:

• Profit Target: Our profit target is the previous day's closing price.
• Stop Loss: Our stop loss is placed above the high of the day.
• Time Stop: If the gap has not filled within 3 trading days, we will exit the position.

Profit Targets

Our profit target for a gap fill trade is a specific price level, not a multiple of our risk:

• Profit Target: Previous Day's Close

Stop Loss Placement

Stop-loss placement for a gap fill trade is straightforward:

• Stop Loss: Above the High of the Day

Position Sizing

We will continue to use the 1% rule for position sizing:

• Position Size Formula: (Trading Capital * 0.01) / (Stop Loss Price - Entry Price)*

Risk Management

Risk management for gap fill trades is focused on the potential for the gap to continue in the original direction:

• Confirmation: We will only enter a gap fill trade if we see clear signs of weakness.
• Avoid High-Conviction Gaps: We will avoid fading gaps that are accompanied by high volume and a strong catalyst.

Trade Management

Managing a gap fill trade is relatively simple:

• Set and Forget: Once we have entered the trade and placed our stop loss and profit target, we will let the trade play out.

Psychology

Fading gaps can be psychologically challenging because it involves going against the prevailing momentum:

• Contrarian Mindset: You must be comfortable taking a contrarian view and selling when others are buying.
• Discipline: It is important to stick to your rules and not get shaken out of the trade by minor fluctuations.

By incorporating a quantitative approach to gap fill probability analysis, you can add another dimension to your swing trading and profit from both gap continuations and gap fills.