Last week I demonstrated the technique a trader can use in order to identify the morning reversal of the S&P 500 index due to program trading. I also hinted at another technique that may be used to trade individual stocks during the morning rush and gap fills. Today I will explain it in more detail.
Looking at the following chart, you can see that the S&P 500 futures (on top) trades for 23 hours a day, while the S&P 500 index is only open from 9:30am EST to 4:00pm EST. That means that the futures can and do respond to news that is released before the stock open or to European and Asian market movements.
Checking the fair value on www.indexarb.com just before the open for the stock market tells me that the futures should be trading below the index by 5.21.
Since the futures rallied sharply in the early morning hours, they were trading well above their fair value. The index will gap slightly but not all of the way to where it will be above the futures by the fair value amount. That means that it should rise sharply when the bell rings. Adding the fair value to the futures trading price tells us the target the index will look to achieve on the open. Remember that the futures will also move, so the exact target will be when the two are separated by fair value.
Since the SPY will gap on the open as it is tradable in the pre-market hours, I instead look to stocks that are gapping opposite of the market’s movement in order to find a trading opportunity. There are many resources for finding gapping stock. I chose to use the Nasdaq’s website to see the most declined stocks in the pre-market.
I usually only look to trade the stocks that are priced above $15 and do not trade the ETF’s for this technique. You can see that there are three such stocks. I also looked at ACHN since it was trading close to $15.
These stocks that were gapping down were likely to be pulled up by the extreme bullishness of the broad markets at the open. They make better trading candidates when they are gapping down into demand zones as well.
When the opening bell rang, the S&P index gapped up slightly and then quickly rallied for three minutes until it was trading above the futures by approximately 5.21, the fair value. Notice that the futures sold off slightly as well. That is why the initial target for the index was not met.
Notice how the stocks quickly rallied when the market was moving up. Shortly after the market stalled, they started to fall as well. This time the market rallied for three minutes. The stocks were carried by the bullish momentum and rallied for about five minutes from the open. A trader could have bought the stocks at the open, provided they were gapping into demand, and sold them for a quick profit when the S&P 500 index stalled.
The same technique would be applied when the index must drop to meet up with a down futures market. A trader would look for stocks that were gapping up into supply and short them until the index dropped sufficiently.
There are no guarantees in the markets and this technique is, of course, not going to work all of the time, However, it is a phenomenon that occurs on a regular basis and an experienced trader can take advantage of it and trade alongside of the program traders.