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Market Primer: Tips For Trading A Gap Opening

A short squeeze occurs when there is a rush of short sellers being forced to cover
positions.  Take a look at the futures quotes to the left.  This is the epitome of a short squeeze.  Prices rise wildly upwards until the short sellers capitulate.  At this point short sellers are in maximum pain and all they want to do is get out of their position no matter what the cost.  A short squeeze is a bears worst nightmare.

Is there a new fundamental reason the market should rally?  What has changed from last week when the whole world seemed to be falling apart and the news was rampant with speculation of a recession?  Absolutely nothing.

The futures quotes above represented the start of the Asia trade.  One hour into the Asia trade the market looks like this:

Why do I point this out?  To encourage those who remained directionally short over the weekend not to panic sell at the open. No one ever made a dime from panic selling.  Your risk on Friday is the same risk you face on Monday.  If it was an acceptable risk on Friday, it should be an acceptable risk on Monday.  There are several things I do when on the wrong side of a gap up open.

1.  Remind yourself not to panic.  You know that feeling of dread you get in the pit of your stomach?  Get rid of it.  Accept the fact that you cannot change what is going to happen and instead focus on what positions can cause the most damage and a course of action for each.  Write it down.  Having a plan of attack means you won't make rash decisions in the heat of the battle.

2.   Identify what positions you intend to keep with a valid reason why.  Not wanting to take a loss is not a valid reason to keep a losing position.  Your portfolio has already sustained the draw down, accept it and move on.

3.  For those positions you don't intend to keep, consider removing any limit stop orders as the market will gap up and likely skip your order for sale at a specific price.  In my personal trading I remove all stop orders for the opening trade so as not to be filled at the worst possible price. After the first 10-15 minutes I replace my stops using a stop market, NOT a stop limit.  The premise here is that the pro's fade the open (they take the other side of a strong directional open).  After your stops are replaced let the market take you out of your position.  You are still likely to take a loss, however, if you don't panic and sell at the open you may find a better exit and have a smaller loss.  Only you know your personal risk tolerance and it should be well defined before you make your first trade.

4.  Focus on limiting losses instead of chasing the opening price.  Nothing goes straight up and you will likely have a better opportunity to enter at or below the opening price.  Stop your portfolio from bleeding then bandage the wound.

5.  Remember that the market can remain irrational longer than you can stay solvent.  You may think you can withstand looking at a big loss, however, the majority of retail traders give up and sell right at the bottom of a strong directional move.  Identify support and resistance and write it down.  Decide what number is your line in the sand and stick to it without question.

6.  Turn off the TV and focus on the numbers.  Numbers are the cold hard truth of trading and you don't need the distraction of the talking heads speculating why the current move is happening.

7.  If you exit a position at a big loss, don't beat yourself up.  Your trading does not define you as a person and the balance in your account is not representative of your self worth. 

8.  If you are uncomfortable with your loss, determine WHY.  Are you trading too big?  Are you overweight in a sector or an individual stock?  It feels great to have a big position in a name that's going your way, but, professional money managers worry more about what they could lose vs. what they could make.

9.  Set your stops and walk away.  The market is going to do what it is going to do.  Make a fresh pot of coffee, go for a walk, pet the dog.  In doing this you physically separate your emotions and your trading account.

10.  If you are frozen like a deer in the headlights, phone a friend.  Your friend has no emotional attachment to your money, therefore, you will likely receive an objective opinion.  I have a backup trader who will take action when I can't, and the standing agreement is that there is no "I told you so", only action and evaluation.

Let's take a look at the futures quotes now that we are not in the heat of the moment.  What happened to price?  It declined and offered a better opportunity for entry and exit.

Always respect the larger trend.

I share these insights in an effort to remind you to plan your trade and trade your plan. Today's buyer becomes the next potential seller.  There is no room for a middle man.

Each trader has a different style, means and tolerance.  What is acceptable for me might not be acceptable to you.  I recall a quote from one of my favorite shows, Hill Street Blues, "let's be careful out there".