March 1, 2008
Dealing with Gap Openings
The Box suggested a bunch of shorts these last couple days and then the major averages all tank two to three percent … purely a coincidence of course. :-)
Commenters Bob and Michael asked a very timely question about how to deal with gap openings. I guess there are two ways to look at it:
1) Since I suggest entering positions using stop limit orders, if your limit price isn’t hit then you’re not going to get filled and you miss the trade. For record-keeping purposes I’m using a stop limit one cent above/below the entry level, but I know many people are using wider limits, like five or six cents above/below the entry level.
2) If price gaps beyond your stop limit price and you’re still interested in taking the trade I would suggest recalculating the risk/reward and adjusting your position size. Let’s look at an example of this with DRQ, one of yesterday’s short ideas.
So if you were risking $250 on the trade (1/4 of 1% of your $100,000 in risk capital) you’d be looking to short around 107 shares (107 shares times $2.33 initial risk is $250).
Here’s the chart from February 28th, annotated with the key levels:
On Friday, DRQ opened at 50.55, which is way below our expected entry level just below 51.01. Now if you still wanted to short it, you’d have to recalculate your risk/reward to see if the new entry price made sense. You can see from the spreadsheet below that entering at 50.50, the new Initial Risk $ is 2.84 giving a Target 1.0 risk/reward of 2.3R — this is still acceptable (anything above 2 is OK with me).
Any entry above $50.13 would still give a better than 2 to 1 risk/reward to Target 1.0, but you don’t want to chase anything too much and the higher the minimum expected reward the better. As you know, the Box generates ideas nearly every day so there’s no great need to chomp at the bit.
To keep the original $250 of dollar risk, you’d have to reduce your position size given the new Initial Risk $ of 2.84. (88 shares times $2.84 = $250.)
Am I being clear here? Does this make sense? I’m a little hungover this Saturday morning so please let me know if my logic is flawed. :-)
March 2nd, 2008 at 1:44 am
hello, i found your site from a link on tradergav, i’m new to trading and have my own (very small) account for forex on fxcm.. ? can you recommend any good places to start in order to begin making a good technical system ,eg simple entry, solid risk management, good exits ? i’m trying to keep it simple but am continually getting whipsawed.. i win say 3 or 4 good small trades and then lose 2 big ones only to wind up back at the beginning … any help or pointers gratefully recieved.. Gavin
March 2nd, 2008 at 10:47 am
CM: This was helpful. thanks for taking the time to go over this.
March 3rd, 2008 at 11:38 am
Can you talk about gaps in the opposite direction? For example, what if DRQ gapped up above the protection stop? Is it still a short then?
Thank you
March 3rd, 2008 at 11:51 am
Regarding the “Target 1.0″ and “Target 1.1″ price targets, do the rules say we should close out the position at these levels (for example half@1.0 and the rest@1.1) or should we still let the trailing stops do their thing?
March 3rd, 2008 at 12:01 pm
Lawrence: Sure, if it later traded down through our entry level then we’d still get short, but once again you’d have to think about whether the original protective stop still makes sense given the spike above it that you describe — that might change the risk/reward scenario and you’d have to recalculate things and see if it made sense still.
As far as exiting at Targets 1.0 or 1.1, my preference is simply to trail the stop and let it run as long as possible. You have to apply some judgment of course, there are no hard and fast rules, though for book-keeping purposes, I strictly stick by trailing stop.