Granolabar's Gap Down Guide (my own style)Introduction
Within the past week, AMEX:SPY has become increasingly volatile, with massive gap ups and downs
followed by all day runs extending more than 3% in either direction. This is apparent with a cursory glance at the following chart.
With this volatility comes uncertainty, especially for those who are swing trading on the timeframe of a few days to a few
months. However, we can use this increased volatility to our advantage. i am going to introduce my way of trading these days,
particularly the ones involving gap downs.
Identifying the Setup
Identifying the setup is relatively simple, but there are a variety of factors that can improve your chances of success.
Firstly, the stock needs to have gapped down overnight. This one is quite obvious and easy to identify; look for a literal gap in
the prices going from after hours to premarket, like those identified in the following chart of SPY.
Secondly, there are a few things that can improve the chances of this strategy playing out. For example, if the stock recently hit
a supply zone and rejected, the gap down is more likely to be followed by more downside as the stock is already in "pullback
mode."
Additionally, trendlines are another great thing to keep in mind. For example, SPY recently hit a nearly 4 month long strong
trendline and rejected. Generally speaking, the larger the timeframe that the trendline is identified on and the more "touches"
it has, the stronger it will be. I often find it useful to work my way down from the 1 month or 1 week chart down to the hourly
to identify trendiness that I need to keep in mind.
Trading the setup
To trade this setup, I like to primarily stick to the 5 minute chart. The one minute chart has too much noise, while the 15 minute
takes too long for confirmation that you would miss a sizable amount of the move.
Once you are on the 5 minute chart, draw a horizontal line at the bottom of the premarket low, as shown below. This will be the
critical value to watch. Theoretically, you want to enter when that line breaks , BUT there are often fakeouts
around these critical levels.
To know when to enter the trade, I watch the candle sticks. First, there must be a 5 minute candle that closes below the
premarket low. Then there are two possible scenarios from here.
Scenario 1, the next candle immediately pushes below the low of the first candle. In this case, you would take puts or sell
short as soon as the second candle breaks the low. My reasoning for this is that if the movement is strong, the second candle
would not hesitate to make a new low. It is better to enter on the break than to wait for the candle to close and miss out on
potential profits, which are often pretty sizable when things are moving quickly. Notice in the below example that had you
waited for that candle to close, you basically would have missed half of the entire fall, which lasted 4 5 minute candles.
Scenario 2, the next candle does not immediately push below the low of the first candle. In this case, you would wait until there
is a candle that closes below the low of the first, instead of merely making a new low. My reasoning is that if the
momentum is not strong enough for the second candle to immediately make a new low, the confirmation candle to enter needs
to be more definitive. The play is not invalidated because the first candle closing below the premarket lows indicates that there
is downwards pressure. In this way you minimize the likelihood of shorting a bear trap while also capitalizing on the fall.
Let's Talk Take Profit and Stop Losses
Now that you have successfully entered the position at an optimal place, the next thing to consider is where you want to exit,
whether that is to secure the tendies you just made or protect yourself from further losses. Note, this part is completely up to
you and your risk or reward tolerance.
Assuming that it all goes to plan the the stock starts to fall:
I typically trade weekly options for this kind of play, as it is a short term play. Because options premiums move quickly in both
directions, I will take profit at 25% with about half the position if the candles are getting smaller, indicating that the trend may
be weakening. Then I will set a stop at open, meaning that I will sell the remaining portion of the position if the contract goes
back down to my purchase price; this guarantees that ultimately the play is profitable.
However, if the candles stay rather large, I will hold the position until the candles do start to get smaller, and sell half the
position there, often around the 50%, 75%, or 100% profit mark. If the option does hit 100% profit, I will almost always sell half,
with very very few exceptions. This ensures that even if the other half of my position expires worthless(worst case scenario), I
come out of the play completely unscathed.
If the play does not go according to plan:
Let's assuming that right after you enter based on the conditions above, the stock reverse to the upside. Now the question
becomes, when do you sell to prevent yourself from taking major losses. For this I use my EMA clouds, or simply just EMAs with
the region between the lines shaded in. I typically have a 5/12 EMA cloud (green) and a 34/50 EMA cloud (blue).
As soon as one candle closes above the 5/12 green EMA cloud on the 5 minute chart , and the next candle closes
above the first candle, that Is when I take the loss and move on. Often times, when playing this strategy, the price will come
back up and retest the break line; do not panic if the position is immediately red, but also stick to the stop loss rules mentioned
above.
This cloud strategy also applies to closing the last half of the profitable position mentioned above. When you are left with half a
position at 100% profits or more, I will wait for reversal to sell. The reversal tends to happen when one candle closes above the
34/50 EMA cloud on the 1 minute, and the next candle pushes past the first high. There are also many other ways to market the
bottom, such as bullish divergence, engulfing candle, abandoned baby, etc.
TLDR
This is my way of trading gap downs that utilizes candle sticks and the EMA clouds to determine Stop loss or Take Profit places.
Simply put, buy puts when the price cleanly breaks the premarket low, ride with the clouds until they suggest a reversal or
hit a stop loss point.
if you have any questions or comments, please feel free to let me know. I would love to hear other perspectives or criticisms.
Also, the "clouds" are just EMAs filled in with crayons, but if you want the script, it's in my profile.
