Trends, Gaps, and Probabilities…
Last week, I wrote about trading and gambling. Specifically, how trading is the one form of speculation on the planet that allows you to stack the odds in your favor before putting any of your hard earned money at risk. That discussion was fine but this week, let's begin to qualify the difference between some higher probability opportunities and lower ones as knowing the difference is a key to success.
In the Extended Learning Track (XLT) – Futures Trading and Forex Trading programs, a market situation we are often faced with is a gap. We use a simple checklist based on objective information to determine exactly what action to take (or not to take). The checklist helps us determine the probabilities, risk, and reward. Here is how some of it works:
Downtrend:
1) Gap up into an objective supply (resistance) level
In a downtrend, selling short on a gap higher into supply is likely the highest probability trading opportunity there is. This is because only your most novice trader would buy after a gap up in price, into a supply level, and in the context of a downtrend. Therefore, we want to be the seller to that buyer which means the odds are stacked in our favor. This type of gap is likely to get filled very quickly.
2) Gap down into an objective demand (support) level
One might think a gap down into demand is a buying opportunity right on the open of trading each time we see it. However, when we consider this action in a downtrend, this trading idea becomes a bit lower probability. While this gap is likely to fill and almost always does, it typically takes a bit longer than gap scenario #1.
Uptrend:
1) Gap up into an objective supply (resistance) level
This gap up into supply is a trading opportunity that we consider shorting as long as the risk is low and reward (target) is high. However, this is not one of our highest probability trading opportunities because we are shorting in the context of an uptrend. This gap will typically fill within the day or soon after but the higher probability gap trade to take in the context of an uptrend is scenario #2.
2) Gap down into an objective demand (support) level
In an uptrend, buying on a gap down into demand is likely the highest probability trading opportunity there is. This is because only your most novice trader would sell after a gap down in price, into a demand level, and in the context of an uptrend. Therefore, we want to be the buyer to that seller which means the odds are stacked in our favor. This type of gap is likely to get filled very quickly.
If you have not figured it out yet, the key factor in determining which gap scenario offers us the greatest odds is a direct function of identifying who is making the biggest mistake. Someone buying a gap up, into supply (resistance), and in the context of a downtrend is making a very big mistake which means they are buying when the odds are stacked against them. Therefore, we want to take the high probability trade and be the seller to that novice buyer. To summarize, the two highest probability gap trades are selling short when there is a gap up into supply in a downtrend and to buy on a gap down into demand in an uptrend. Of course, there is a little more to it than that when it comes to trading. With any of these scenarios, the risk must be low and the reward must be high and this is objectively determined off of the price chart (and a topic for another article).
Hope this was helpful. Have a good day.
Sam Seiden – sseiden@tradingacademy.com
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Sam brings over 15 years experience of equities, forex, options, and futures trading which began when he was on the floor of the Chicago Mercantile Exchange. He has traded equities, futures, interest rate markets, forex, options, and commodities for his personal interests for years and has educated hundreds of traders and investors through seminars and daily advisory services both domestically and internationally. Sam has been involved in the markets since 1991 both on and off the floor of the Chicago Mercantile Exchange. He has served as the Director of Technical Research for two trading firms and regularly contributes articles to industry publications. Sam is known for his trading, technical research, and educational guidance.