If I had a dollar for every time someone asked me, Of all the setups you have, whats the one setup that works best all of the time? Id have my kids’ college already paid for, as well as their graduate school and their weddings.

And Id probably be able to take care of my in-laws too, and their numbers are considerable.

There is no easy way around it.  There is no magic bullet.  Different setups work better in different market conditions.

That said, one of my all time favorite “quick trades” are gap plays.

What in the world are gap plays?

Gaps are contrarian plays, or “fade plays” as I like to call them.

Opening gaps create a lot of excitement and emotion in the market participants, and I like to step in and take the opposite side of this emotion. The play is completely against the crowd, which I like, and is one of the lowest-risk trades available.

What exactly is a gap?

Gaps occur when the next day’s regular cash session opening price is greater or lower than the previous day’s regular cash session close, creating a “gap” in price levels on the charts, similar to that space we see each night between David Letterman’s two front teeth.

When it comes to gaps, not all markets are created equal.

Gaps in “single item” markets do not act the same as gaps in “multi-item” markets.

Examples of single-item markets include bonds, currencies, grains, and individual stocks. These gaps typically fill at some point, but not necessarily on the same day. For this play, I’m specifically interested in gaps that have a high probability of filling on the same day they are created. For these single-item markets, a news item controls the entire order flow for that day, instead of affecting just a small portion of an entire index.

This is especially true of individual stocks.

Individual stocks are like politicians, in that each day they can produce a fresh skeleton from the proverbial closet. Earnings announcements, corporate scandals, and insider deals can create gaps in price that never get filled. Bernie Ebbers certainly wishes his Worldcom stock would fill its overhead gap. Unfortunately, the odds of this happening are about the same as Republican and Democratic Senators working together for the good of the country.

Because of the unpredictable nature of individual stocks, they make poor candidates for gap fills. The exception to this is gaps on individual stocks that are gapping with the market and not on any particular news.

How does a person tell this?

If a stock is gapping about the same percentage as the overall market, and there isn’t any news on that stock, then that stock can be played as a gap play.

For example, if AAPL gaps up 1.00%, and the overall S&P 500 is also gapping up 1.00%, and there isn’t any specific news on AAPL, then it can be played as a gap play. It’s just moving with the overall market.

But compared to single-item markets, a multi-item market is a great candidate.

My favorite multi-item market is the SPY.  This is the exchange traded fund for the S&P 500 stock index.  This is a great basket of stocks, and makes a great candidate for a gap play.

Why?

This is because there are individual components of these indexes that will respond differently to various news items. Good news for oil companies is bad news for transportation companies. Good news for defense stocks can be bad news for consumer-related stocks, and so on. This means that, although the market may gap up on a news item, there will be individual stocks within the index that will either ignore the news or sell off on the news.

This weighing down, coupled with an initial pullback in the strong issues that are gapping up, weighs down the entire index, creating an opportunity for the market to fill its gap.

In addition, many fund managers watch the open gaps. They’ve been doing this a long time and know that the markets hate to leave “messy charts” in the form of open gaps. If the markets gap up, they will generally wait to start committing to the long side until the market has pulled back and filled its gap. In this way it is also like a self-fulfilling prophecy.

Long story short, if you have an hour or so to watch the market open, this is what you can do.  If the SPY opens the day down 0.90 cents or lower, then buy it, and close it out when it gets back to “unchanged” on the day.  If it opens the day up 0.90 cents of lower, you can short it, and then cover when it gets back to unchanged on the day.

In other words, playing the gap is a most profitable way to start the day.