Gap Down Strategy

Gap down trading strategies in stocks capitalize on downward price gaps between trading sessions. This strategy outlines specific entry and exit criteria to exploit these opportunities effectively. Entry occurs on the next trading day if certain conditions are met, while exits are determined by crossing the 10-day moving average or reaching a target percentage gain. This approach aims to maximize profits while managing risks. Readers are encouraged to contribute suggestions for refining this strategy further.

Gap down trading strategies in stocks are popular and perhaps for good reason.

Below is a gap down trading strategy in stocks:

Entry:

1. The stock must gap down. That means today’s HIGH must be lower than yesterdays LOW, and
2. Today’s volume must be lower than the average over the last 50 days. This is important. A higher volume most probably means bad news and will likely lead to more selloff.
3. If all the above-mentioned criteria are met, entry is on the next day if the stock falls 0.5 times Average True Range the last 50 days from the open. The reason I want to buy if the stocks fall the next day is that this strategy has no edge over the first 1-4 trading days. Actually, I have a potential twist to this strategy of going short. I’ll publish that later.

Exit:

1. The stocks close above the 10-day moving average, then exit at CLOSE, or
2. The stock reaches a target of 7.5%. It’s better with a higher target, but a lower target locks in profits on “dead cat bounces” during bear markets. If the target is reached, the target price is exit (but if the stock gaps up higher than the target, the OPEN is exit).
3. If neither 1 nor 2 are met, there is a time stop of 15 trading days at the CLOSE. The reason I have chosen 15 days is that stocks have performed well over this period. For a shorter period, it is much more erratic. In general, stocks fall a lot faster than it rises.

My sample is on the S&P 600 stocks that were in the index in January 2007.

Here is the result with 5000 USD per position:

#Fills	Win-ratio	Avg.winner	Avg.loser	Avg.per fill
5434	72.03%	202.43	-332.54	1.06%

Here is the equity curve with max 10 positions (on days with more fills positions are picked randomly) and NOT reinvested profits:

Annual returns are about 11%. 2804 trades in total, ie. a lot of potential trades are not taken.

Now, this strategy can also be traded with an entry on OPEN, ie. go long on the open in point 3 on the entry criteria and not wait for a drop from the open. The results are still very good with an annual return of 12% (higher return because of a lot more fills).

Do any readers have any inputs/suggestions?

Why is lower trading volume considered important in gap down trading?

Lower trading volume, compared to the average over the last 50 days, can indicate a more controlled selloff, making it a critical factor in this strategy.

When is the entry point for the gap down trading strategy?

Entry occurs on the next trading day if the stock falls to 0.5 times the Average True Range (ATR) over the last 50 days from the open. This entry approach accounts for the fact that the strategy has no edge in the first 1-4 trading days.

What are the exit conditions for the gap down trading strategy?

The strategy provides exit options, including exiting if the stock’s closing price rises above the 10-day moving average or achieving a target of 7.5%. If neither of these conditions is met, there’s a time stop of 15 trading days at the close.

What is the rationale behind waiting for the next trading day to enter the market in this gap down trading strategy?

Waiting for the next trading day allows the strategy to avoid early volatility and uncertain market movements, ensuring a more calculated entry point based on specific criteria.

How does this gap down trading strategy aim to manage risks while maximizing profits?

By setting clear entry and exit criteria based on technical indicators like moving averages and trading volume, the strategy aims to limit losses and capture potential gains effectively, thus balancing risk and reward.