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Gap-and-hold and mean reversion

Lesson 16 · about 11 min

The last two setups cover the situations the first three do not: a stock that has just repriced on news, and a market that is not trending at all. They are used less often and sized smaller, but each fills a gap in the playbook that would otherwise tempt you into forcing a pullback or breakout where none exists.

Setup 4: gap-and-hold continuation

A stock gaps up 5% or more on earnings or major news, and instead of fading, holds the gap for the rest of the day and closes strong. The gap has repriced the stock and institutions who cannot buy their full size in one day keep buying. The trade is the continuation.

                 ___/  <- entry: close above gap-day high (day 2 or 3)
     gap day  |‾‾|__/
   ___________|  |      stop: below the gap-day low
  /           gap
 /            (5%+)

Conditions:

  1. Gap of at least 5% above the prior close, on volume over 2x the 50-day average.
  2. The gap day closes in the top third of its range and above its open.
  3. The gap does not fill: the gap-day low stays above the prior day's high.
  4. Regime green or amber. The stock does not need to be a leader beforehand; the gap may be what makes it one.

Trigger. A daily close above the gap-day high within the next three sessions. Alternatively, a two-day tight pause above the gap-day midpoint followed by a trade above the pause high.

Stop. Below the gap-day low. If that is more than 2.5 ATR away (the gap day was very wide), use the low of the pause instead and accept a lower success rate.

Targets. Add the gap-day range to the entry for target 1; trail the rest with the 10 EMA, because post-earnings drifts can run for weeks.

Element Price Distance In R
Entry (close above gap-day high) $73.50 — —
Stop (gap-day low) $69.20 $4.30 1.0R
Target 1 (entry + gap-day range of $4.10) $77.60 $4.10 1.0R
Target 2 (trail 10 EMA; typical outcome 2.5 to 4R) — — 2.5R+

Target 1 at 1R is normal here; the payoff comes from the trail. Size at 0.75x your standard risk.

Invalidation. A close below the gap-day midpoint within the first three days; a fill of the gap at any point; volume that collapses to below average on day 2 with a red close.

Setup 5: mean reversion to the 20 MA in a range

When the index and the stock are both rangebound (amber regime, flat 50 and 200 averages, 20 EMA weaving through price), breakouts fail and pullbacks have no trend to resume. What works is the opposite: buy the extension away from the 20 MA and target the return to it.

                                20 MA (flat)
   /\      /\        /\      -----------  <- target: the 20 MA
  /  \    /  \      /  \    /
 /    \  /    \    /    \  /
       \/      \  /      \/   <- entry: close back inside after 2+ closes
                \/               more than 2 ATR below the 20 MA
                 stop: below the extension low

Conditions:

  1. Index regime amber with a flat 50 MA; the stock's 50 MA is also flat or slightly rising.
  2. Price has closed more than 2 ATR below its 20 SMA for at least two consecutive days. (Use 2.5 ATR in crypto.)
  3. No earnings inside 5 days and no news driving the drop. Mean reversion is for noise, not for information.
  4. The stock has a history of respecting the range: at least two prior touches of the range bottom that held.

Trigger. A daily close higher than the previous day's close, with the day's low above the extension low. This is a reversal day, not a breakout.

Stop. Below the extension low with a 0.5 ATR buffer. Wider than usual because reversals are noisy.

Target. The 20 SMA itself. Exit the full position there; do not wait for more. This is the only setup in the playbook with a single fixed target and no trail.

Element Price Distance In R
20 SMA $31.00 — —
Entry (reversal close) $27.80 — —
Stop (extension low − 0.5 ATR, ATR $1.10) $26.45 $1.35 1.0R
Target (20 SMA) $31.00 $3.20 2.4R

The R:R is attractive because the entry is far from the mean; the losers are quick. Size at 0.5x standard risk and cap the hold at 8 trading days: if price has not reached the 20 SMA by then, exit at the market.

Invalidation. Any close below the extension low; a regime change to green (breakouts and pullbacks take over) or red (the range is breaking down); news arriving during the hold.

Key idea: Gap-and-hold catches information the market has not fully priced. Mean reversion catches noise the market has over-priced. Use each only in the regime it belongs to, and size both smaller than the three core setups.

How the five fit together

Setup Regime Size vs standard Typical hold Target style
Pullback to rising EMA Green/amber 1.0x 5 to 15 days Partial + trail
Breakout from base Green only 1.0x 5 to 20 days Partial + trail
Failed breakdown/reclaim Any 1.0x (0.25x in red) 5 to 15 days Partial + target
Gap-and-hold Green/amber 0.75x 5 to 20 days Trail
Mean reversion to 20 MA Amber 0.5x 2 to 8 days Single target

If you find yourself taking a setup outside its regime column, you have found the trade that will show up in the "what went wrong" section of your monthly review.

Try it: Find the last earnings gap of 5% or more on a stock in your universe and mark the gap-day high and low, the trigger day, and where the 10 EMA trail would have exited. Then find a rangebound stock and locate the last time it closed more than 2 ATR below its 20 SMA. Build both R:R tables.

Recap

  • Gap-and-hold: 5%+ gap on 2x volume that holds; enter on a close above the gap-day high; stop below the gap-day low; trail with the 10 EMA; size 0.75x.
  • Mean reversion: only in a flat range; enter on a reversal close after 2+ days more than 2 ATR below the 20 SMA; stop below the extension low; exit fully at the 20 SMA; size 0.5x; 8-day time limit.
  • Neither is a substitute for the three core setups; they cover the two situations the core setups cannot.
  • The regime column decides which setups are on the table; the size column decides how much.

See it drawn

Original diagrams for the ideas on this page. Illustrative, not real market data.

Risk and reward on one tradeA price scale showing an entry with a stop two points below and a target six points above, so the reward band is three times the risk band.PRICETARGET 106.00ENTRY 100.00STOP 98.00REWARDRISK6.00 pointsthree times the risk2.00 pointsthe most you loserisk : reward = 1 : 3
Risk and reward on one trade. One trade on a price scale: the entry sits 2.00 points above the stop and 6.00 points below the target, so the shaded reward band is three times the risk band. The ratio compares what is lost if the stop is hit with what is gained if the target is reached.
A range beside a trendOne chart swinging between a flat floor and ceiling, another stepping upwards inside a pair of sloping lines.Range-boundresistancesupportprice bounces between two levelsTrendingthe trend channelhigher highs and higher lowsA range has two flat edges; a trend has two sloping ones.
Range versus trend. On the left price keeps bouncing between the same floor and ceiling, which is a range. On the right each high and each low is higher than the last, inside a pair of sloping lines called a channel.
Breakout and retestPrice stalls under one level, pushes above it, comes back to touch it from above, then continues higher.pricetimeold resistancenow support1price keeps stalling2breaks above3pulls back and retests it4and carries on
Breakout and retest. Price stalls under the same level several times, pushes above it, then drops back to touch it from above before carrying on. That touch is the retest, where the old ceiling is tried as a floor. A break that falls straight back under it is a false breakout.

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