2 Best Grain Markets for Gap Trading

05/18/2012 1:15 pm EST

Focus: COMMODITIES

Scott Andrews

CEO & Co-Founder, InvestiQuant

Trader Scott Andrews uses a gap fading strategy to trade commodities like corn and soybeans, and here, he tells how to define stop placement and profit targets for such trades.

Fading the gap in commodities. We’re here with Scott Andrews and we’re going to talk about something new that he’s found that’s working well for him. 

I’ve been studying corn, soy, and wheat, and I’ve found that wheat doesn’t work quite as well for gap fading. It tends to be more market neutral, but surprisingly, corn and soybeans can have their opening gaps faded.

You need to be patient and wait a minute—literally a minute until after the market opens—and then look to enter. If the gap is up, you short it; if the gap is down, you buy it. 

I’ve also stumbled on a few things that will help your results. One is stop size. Surprisingly, similar to what works well for me in the financial indices, is 30% of the five-day average true range (ATR). The average true range pretty much is the high to the close on the average of the past five days, inclusive of gaps. Average that and use 30% of that number. That’s a good benchmark and it actually works really well in corn. 

Soy, I think, does a little bit better with a 40% stop, and then wheat, I think, was 20%.

Thirty percent is a good benchmark for trading the gap. It increases your profitability, and those gaps that don’t fill, you’ll get stopped out, but it keeps you from losing a bunch of money. 

Extended targets: I’m surprised because a lot of folks think of commodities as being trending instruments, and they are to a degree, but you can fade the gap. Once it fills the gap, it often will continue through the gap. Corn, for example, the longer you hold onto it, the more money you make.

Now, the win rate goes down, but you’ll make the most money if you get a gap filled on corn, then be patient and hold it until the end of the day. So that’s a little bit of food for thought. 

Personally, I would trade it and maybe target half the gap fill and hold half or a third for some point beyond the gap fill, which is what I call an “extended target.” 

Day of the week, and interestingly, corn is a little bit different than the financial indices. I don’t trade the opening gaps on Mondays very often in the S&P, for example. It just tends to be more volatile. But with corn, Monday, Tuesday, and Wednesday are good days to fade the gap. Thursdays and Fridays tend to be more neutral. 

Gap size is an important one. Pretty much in any instrument you’re trading, you want to pay attention to gap size. It will dramatically impact the win rate. What I’ve found in the commodities is 40% of the five-day average true range—the exact same number I use for financial indices—tends to be a really good delineator between higher risks.

The bigger the gap, the lower the probability of failing versus the smaller gaps. Small to mid-sized gaps up to 40% work really well. I would have never guessed it would have worked as well on commodities, but they pretty much do.

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