2 Recent Gap Trades That Worked

06/29/2012 7:00 am EST

Focus: STRATEGIES

Gap Edge Trading’s Troy Peterson discusses the key traits of a successful trader, and says that sometimes it’s wise to take a breather if your set-ups are not working—whatever your trading time frame. He cites two recent gap-downs that he was able to trade successfully.

Kate Stalter: Today, my guest is Troy Peterson of Gap Edge Trading. Troy, one thing that I was pretty curious about asking you about today: The volatility, in recent sessions, has returned to the equity markets with a vengeance. Talk about how that has or has not affected your trading system.

Troy Peterson: Yeah, that’s a very good question. That has actually affected our trading system, too, in a good way, pretty much the whole year, from the end of December to all the way up until the end of March.

The market was in a really nice continuation uptrend, and then we got into May, and then things started to unwind. And once that happens, a lot of our strategies that we do at Gap Edge Trading, with gaps, the market seems to kind of unfold and unwind for us.

And because that whole position has been built up for the bull, for that several-month period and a lot of winding up, really tight and tight, the bulls are making money. And once the tree gets shaken a little bit, the volatility increases, the VIX goes up, and people start camping out and getting out of the market for the meantime.

Sell in May and go away, right? That kind of played out perfectly well this year for seasonality. So, yeah, it works really good.

My business picks up, because I think a lot of people don’t know how to play the market when it gets a bit volatile, because it throws a loop, maybe scares a lot of people. But I personally, as a day trader, with my traders, we love it. Because, if you notice how tight the SPDR S&P 500 (SPY) was all the way through the uptrend, the days were really, really tight. The ranges were narrow…they weren’t big ranges.

So once you got the volatility, and the market started to double top on the SPY and we start pulling back, the days started getting bigger. And then we had that big, big day going on last week, which was Thursday [June 21]—that big distribution day, the selling day—that was a big day. Then we also had before that we had one of the bigger days up on the year, a few days before that. So just a very fun market.

Kate Stalter: Let’s talk about a topic that I’ve actually been speaking with quite a few people about in some of these interviews, and that’s the profile of a successful trader, and what steps a person has to go through in their development as a trader to become successful.

Troy Peterson: Oh, yes, it’s very good. I personally enjoy helping traders along the journey. Now, I was on the journey myself, and still am on that journey.

“Introspection” is what I’ve always defined trading as. People want to grasp onto more knowledge. Well, knowledge isn’t good when it comes to trading. You need to have knowledge, but I think the better understanding, of what comes to the development of traders, is to know yourself.

The Chinese proverb was, “Know yourself, and then you’ll know your enemy better.” So the more that you know yourself and your personality and even your drawbacks—your negative side, your emotional, your hangups—because none of us are perfect. We all come to the trading arena for the same reason. So nobody comes wanting to lose, and we all come with some sort of baggage. So the more you know yourself, I think, is one of the biggest, biggest advantages you can have in trading.

If you know that you’re making this mistake and the reason you’re making it—if you can understand why—and then you can kind of contain it, you know and understand it and defuse it. The more that you know about it, the less it can have a hold on you. The more you know about your hangups and your weaknesses, you can defuse them by knowing more about them, because they have less hold on you, and you create rules to follow them.

And then knowing your setups—you’ve got to have a setup that you like. I think, too many traders—you know, the way I was taught to trade, where they gave us like 80 setups, you know. “You can do this setup, that setup”—and then the new trader just kind of goes out there and fires at everything, and they’re kind of like a jack-of-all-trades, masters of nothing, right?

I think one of the keys is know yourself, and then second, to become a master at one type of thing. For me, it’s gaps. For somebody else, it may be different. Sit in your chair and trade, and just wait, like a hunter waiting for that game to come by, and be that specific and that focused, and just become a master at that one thing.

Then thirdly, I think would be to know how that setup fits within the market, because we trade setups within the market, and how the market works. Just view the market.

You know, we were in a nice uptrend through January to March and then begin to pull back, and things change, and some setups don’t work as great in different market types, like in volatility. Or they may work better in volatility. So know yourself, know your setups, and then know the market in which your setups exist—I think it’s a huge development in becoming a trader.

Continued…

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Kate Stalter: One of the things I wanted to talk about were some examples that you could cite—either recently that would be instructive to some of the listeners, or even going back in your own learning process, some lessons you learned either to the upside or the downside.

Troy Peterson: Oh, yeah, absolutely, I would love to share examples. For example, one of the setups I personally love to do is when a stock would gap down, and once it breaks it that long-term support that’s held the stock up for many months or many weeks, I love it. Because basically the stock, what it’s going to do then, is it’s just going to transcend to the next demand area. So that gives the trader a huge advantage.

Well normally a stock will trade—say hypothetically your stock trades between a 50-cent average through a range per day, and that day that it breaks that support level. It may move $3, so that creates a big range that you could capitalize on.

An example of that would be Bed Bath & Beyond (BBBY). It gapped down last week on the 21st, which was Thursday, and that was the day the market came in. I think it did like an expanded 16 million shares that day. It normally does 4 million shares. And it had a huge range, $65, all the way down to $60, and we did our setup on it.

It’s a perfect example of what we would classify—basically, we use gaps as just a hint. I mean I call it Gap Edge Trading, because it’s just a hint of a greater move. And it doesn’t necessarily mean it’s always a trade, but we want a stock that’s going to give us a hint before the market opens, and we want the stock to be in play. We want it to have expanded range, expanded volume, and that’s what we got.

As a matter of fact, another one, for example, was on Friday, which was Ryder Systems (R). It gapped from the $40 support area and then opened up at $36 and then made its way all the way down to $35, which was also just a nice bearish loop—while the market that day was pretty much a narrow-range day from the previous sell-off Thursday. On Friday, it was pretty tight and quiet.

And while we were making money shorting Ryder, it went even lower, because it broke support. People will say to me, “Troy, you go short a lot.” Well, you know, I do, but I do go long, when the market provides some opportunity. I mean, January through March, pretty much everything was a long play. You didn’t want to get caught in the headwinds.

So you just have to be flexible. People will say, “Well, why won’t you go long?” And I say, “Well, if the market can make a new high, gets back up on an uptrend.” It just depends on the seasonality. But right now it seems that the gap-downs are working quite successfully in the last two months.

Kate Stalter: That’s interesting, what you just said, that sometimes people are surprised that you’re not trading in the opposite direction that the market is trending. But it seems that what you’re saying is: Allow the trend, for the most part, to tell you where you’re going to be making your trades, not try to fight the market. Well, would that be true?

Troy Peterson: Oh, absolutely true, absolutely true. I mean, when I look at a stock that may gap before the market opens, I may even go back to the monthly, the weekly. I start at the highest time frame to figure out the trend. And if the trend has been violated.

If that trend was never violated, it was an uptrend and it does gap a little bit, it’s a no-trade for me. It wouldn’t be a short, because it’s still in an uptrend. The bulls still own the stock, so I respect the trend, and I value the trend.

You know the old adage is, “The trend is your friend.” And that’s the truth. In any market, in any type of trading. You know, on the micro-level it’s true. Following the trend is a very important aspect of trading. You know we don’t ever fight the trend.

There are some setups we do that we may go against the trend, and that is when the stock has reached the point of extreme, where if it’s coming down—let’s say the stock has been down like four or five days in a row, it sold off four or five days in a row, maybe six days in a row, and then it has a massive gap to the downside. And if that gap to the downside was to a key support area, we would go countertrend and go long.

There are a couple of setups you do that on, but 80% of the way that I trade, and the way that I teach traders to trade, is to stick with the trend overall.

Kate Stalter: Troy, what would you say today just to wrap up for people who are struggling in this volatile, trendless market we have had, and trying to perfect their own trading systems? What would be your advice?

Troy Peterson: My advice is: You stick with your method. When things aren’t working, there are either two things you could do. I think the worst thing you could do is just keep batting, aimlessly swinging at each pitch. Just sit back, let the market gather itself.

One of the things as a trader, whatever time frame of trader you are, maybe short-term or longer-term, you don’t always have to be in the market. You don’t always have to be trading. Sometimes it’s OK to sit out. And that doesn’t make you not a trader, but it makes you more of a professional by knowing when it is OK to sit out.

You don’t see your setups; they are not working. Just maybe scale back the risk. That is very good to do if things are not working out, and the scenario has changed. You have to adjust yourself and adjust your setups, and scale back your risk and take smaller size and risk less until you can gather some momentum to your trades that you are taking.

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