MTG Opening Gap Rules

 

Due to large changes in overnight supply or demand, both the major market indices and individual stocks will often open much higher or lower than where they closed the previous day, which is known as a "gap." Buying or selling short a stock that hits its trigger price due to an opening gap is sometimes riskier than entering a stock that trades through its trigger price in an orderly fashion. Likewise, open positions will sometimes gap open beyond their stop prices, but immediately reverse back in the right direction. Therefore, MTG has instituted the following rules to manage positions that gap open beyond their trigger or stop prices. This article explains how MTG treats opening gaps, but is not to be construed as advice or a recommendation of a specific strategy.

 

The above rules summarize how we typically manage gaps, and are designed to keep you out of trouble by preventing you from entering or closing a trade at the worst price of the day.  However, just like every other rule in trading, there are always exceptions to these rules that will enable experienced traders to occasionally deviate from these rules with high success rates.  These are nuances that cannot be taught, but can only be learned through experience.  MTG follows these rules every day unless an explanation is provided to subscribers otherwise.  These rules are designed to avert major losses, which is much more important than whether you leave some profit on the table or not.  Here are the different ways the opening gap rule applies to trades, in more detail:

 

4 parts to the opening gap rule - This rule is applied in the event of a significant gap up or gap down in the market that causes an ETF setup to trigger immediately on the open due to an opening gap.  The purpose of this rule is to prevent us from entering a long play at the top of the gap and watching it immediately collapse or vice versa.  The two parts of this rule are as follows:

 

1.)    If an ETF hits its trigger price due to an opening gap, do not enter the position until the ETF trades through the high of the first twenty minutes (or the low of the first twenty minutes if you are looking to short).  For example, let’s assume the plan is to buy SMH if it trades above 24.55 today.  Due to positive news that occurred overnight, the broad market gaps up and SMH opens at 24.67, which is 12 cents above the trigger price. After opening, the highest price that SMH trades within the first twenty minutes of trading is 24.79.  This means that, despite the fact that the trigger price was only 24.55, you do NOT enter the trade on the open, and you only enter this trade if it trades above 24.79 AFTER twenty minutes of trading.  Even though this sometimes results in paying a higher price for the trade, the probability of the ETF going higher is statistically much greater because stocks that set new highs after their first twenty minutes of trading typically go much higher.  However, if the stock is unable to break above its 20-minute high, the opening gap will often represent the highest price the stock will trade that day, which is why you do not want to buy a gap up beyond its trigger price UNLESS it breaks the 20-minute high.  This rule prevents losses time and time again by preventing you from entering a high-risk trade.  When entering a trade that has broken above its opening 20-minute high (or low), you should tighten the initial stop loss to a price that is usually equal to 20 cents below the low of the morning (or high of the morning if you are short).  It is important to raise the stop because you are entering the trade at a higher price than initially anticipated.

 

2.)    On some occasions, a trade triggers on the open and fails to set a new high, but         consolidates by trading sideways near the intraday highs of the first 20 minutes.  If other market internals such as volume, advance/decline line, and the Tick are strong, MTG will sometimes enter a trade despite the fact it has not yet broken the high of the first twenty minutes.  When doing so, the stop is typically set about 10 cents below the low of the day (gap up) which reduces the risk of entering.  Buying without a break of the 20-minute opening high or selling short without a break of the 20-minute opening low is a riskier and more advanced type of trade that beginning traders may wish to forgo.

 

3.)    If there is an opening gap of 1% or more in the direction of a trade held overnight, MTG usually closes half of the position immediately on the open to lock in profits and easy money with at least a 1% gain.  Otherwise, the gap can quickly reverse going into the 9:50 am reversal period, causing profits to disappear.  It is important to note that half of the position is kept open because it often will realize even larger profits on the second half of the shares if the trend continues in the direction of the gap later that morning.  When keeping half of the share size open after a large opening gap, you should typically tighten the stop to just above or just below the high or low of the day (as explained above).

 

4.)    In the event that the market has a large gap in the OPPOSITE direction of a trade you held overnight and causes your trade to be stopped out due to an opening gap, you should consider handling as follows:  If you are long, let the stock or ETF trade for five minutes before selling it and taking the loss.  After the first five minutes of trading, mark the low price that was set during the first five minutes.  If the trade subsequently trades below that five minute low, immediately cut the loss on the whole position.  However, if the trade never violates the five-minute low, hold the trade and watch for a bounce into the 9:50 am reversal period, which you also mark so that you know what the 20-minute high price is.  If the trade now heads south, cut the loss by selling into the bounce near the 20-minute high.  However, if the trade takes out the 20-minute high, you can continue to trail a stop higher.  The purpose of this rule is not to prevent taking a loss (because you will usually still have a loss), but rather to minimize the loss by waiting for a better opportunity to sell into a rally.  If the rally never comes, get out when the 5-minute low is violated.  Statistically, it is worth the risk to wait out the first five minutes because stocks will usually have at least an initial bounce if they get whacked on the open.  Obviously, the inverse of this rule applies if you are short.