Trading the opening gap is a contrarian trade. You are looking to trade in the opposite direction of the gap. You will look to "fade" the gap. The stock market open at 9:30 Eastern time is a time, usually, of high emotions. You are looking to take advantage of those emotions.
What creates the opening gap?
The obvious answer is the price differential between the previous day's close and the next day's open. If your trading the broad market futures indexes, due to GLOBEX, there really is no opening gap. Trade resumes 15 minutes after the close (the close of pit trading and electronic trading for those is 4:15 pm eastern time and trading resumes in GLOBEX 15 minutes after that close at 4:30 pm eastern time) and continues until the open outcry (pit session) with the market open at 9:30 am eastern time. The gap would then be the price differential between 4:15 pm and 9:30 am next day. In the ETF's and individual stock issues, at the present time, there is no trading after the close at 4 pm with the exception of a often VERY thinly traded after hours session for a four hour period. If you are trading in the after hours, word of caution. Your broker may shut down your platform for trading one hour prior to close of the after hours session. You will then be required to call your broker and have him close out your position. That will possibly cost you extra on execution of such an order.
For stocks, the opening gap is created by an imbalance of of buy and sell market orders at the open (also known as MOO which is Market On Open orders). If there is an imbalance of buyers, the NYSE floor specialist and the electronic market makers will open the price higher in an attempt to balance buyers with sellers, Since they are charged with maintaining an orderly market, they will most often sell stock into the imbalance so as to maintain that orderly market. This would make them net short on the open. The reverse would, of course, hold true if there was an imbalance of sellers, they would then supply stock at a lower price and they would be net long at the open. This is important to the understanding of why gaps tend to fill.
Why do opening gaps TEND to close?
The easiest explanationis because NYSE floor specialists and electronic market makers are in business to make money! If the specialist and or the electronic market makers have a net position either long or short, they will seek to move price in the direction of their net position. If short, they will seek to move price down and if long they will seek to move the price up. They accomplish this because they have vital information that you do not. Since they make a market, they have the resting orders! The NYSE specialist has, in his "black book" ALL the orders by price and size away from the market. He has the stop orders! So if he is short, he can move the price lower to trigger sell stops and thus move price lower so as to cover (buy back his stock short position) at a profitable price. If he is long the stock in his book, he will seek to trigger buy stops by moving price higher so as to, again, exit at a profitable price. There are many market maker games also that are employed to move price. This can be a special study all its own. To obtain more in depth understanding of this I recommend Richard Ney's two classics: The Wall Street Gang and The Wall Street Jungle. Also, a fine book by Joshua Lukeman, The Market Maker's Edge.
When do you fade the gap?
This is complex. All gaps are not created equal! I will briefly outline how I view each gap and give you some additional resources. My basic methodology is derived from the pioneering work of Scott Andrews, also known as The Gap Guy. I was a student of his and even was in his trading room for a few months. Since I now have all the data he does and have added my own refinements, I no longer subscribe but it is a very good place to start. Here is the link to his site. http://www.masterthegap.com/ Scott breaks the gap down into 10 zones. Five for up gaps and 5 for down gaps. Here is his zone "map" http://www.masterthegap.com/public/Gap_Zone_Map.cfm Now to utilize this, you will need to know the historical probabilities for each zone for that day based on the combination of 1) day of the week; 2) day of the month as well as identifying pattern risk. If your planning on using Scott's services, you should be aware of the stops he employs in his trades. It is 5 ES points or 30% of the weekly ATR whichever is greater. Be sure this fits within your risk management parameters. Not a futures trader? No problem. You can trade ETF's, stocks and if you are knowledgeable and very nimble, you can even trade options off the gaps! To give you an example of some historical probabilities by day of week for successful gap fills derived from the work of John Carter:
In John Carter's exceptional book, Mastering The Trade, he has an entire chapter devoted to trading gaps. Here are two of my basic rules as applied to ES gap fade trades: 1) I do not consider trading a gap that is smaller than 1.75 ES points and 2) if for any reason I do not trade the gap, I do keep it in mind during the trading session if, according to my trading methodology, a trade is triggered in the direction of the gap. Many gap fill trades can come out of other trade triggers during the session. In pen gap trading individual equities you must be aware if that gap was caused by some announcement directly related to the company you are trading. Was it caused by an earnings announcement or something else directly related to the company? If so, perhaps you should pass on the trade. Could be a gap and go situation! Even if you do not choose to include fading opening gaps within your trading plan, awareness of it can yield other dividends. It can set up price action for the rest of the day. The price reaction to the gap if not filled (gap and go) can give you an excellent heads up for a trend day, etc. I have a little pdf that I found about trading around the opening range (of which, a gap can be a large part of). I would be glad to forward it to anyone who wishes it. It is titled Trading The 10 O'clock Bulls. Email me at Dutch at WeJustTrade dot com if you have not gotten it.
The purpose of this post is not to encourage you to fade the opening gap willy-nilly or without discrimination. You must trade it or choose not to trade it based on your own plan. Do your homework on the subject, see if it fits within your trading psychology, methodology, etc. It is one of my top setups, if not the top setup as, with my own refinements, when do I fade the opening gap, I have better than an 80% positive expectancy for the trade. Awareness and understanding of the opening gap should be a part of every trader's tool box even if you choose not to include fading the opening gap within your trading plan.