Gaps are a category all unto themselves. Lets discuss gaps in two
parts. First we will look at what they are, why they happen and what the
concepts are. Next we will look at some chart examples.
A "gap" is a
term used to describe the circumstance of when a stock opens at a higher
price than it closed the prior day. The word "gap" refers to the
gap that is left in the daily chart; the empty space from yesterday's close
to today's open. Gaps can be either up or down. They can happen to all
stocks, listed or Nasdaq.
The gap is measured
from the prior day's 4 p.m. closing price to the current day's 9:30 a.m.
opening price, all in Eastern Standard Time. The post market activity and
pre market activity do not affect the "gap" for our purposes.
Stocks can trade after market hours through ECNs (Electronic Communication
Networks), until 8 p.m. and pre market starting at 8 a.m., but this is
currently not considered to be "normal" market hours.
For example, stock XYZ
closes at 4 p.m. EDT at 37. It trades in after market hours up to 38. The
next day at 8 a.m. EDT it starts trading at 38.5 and trades up to 39.5. By
9:30 the stock is all the way back down to 37.10. The "gap" as we
measure it is only 10 cents. All those post and pre market trades do not
matter. The stock traded, and people made and lost money, but the gap is
What causes gaps?
Usually it is news driven. Individual stocks can gap up or down due to news
such as earnings reports, earnings pre-announcements, analysts' upgrades
and downgrades, rumors, message board posts, CNBC, or key people in the
company commenting or buying/selling the company stock.
Groups of stocks or
the whole market may gap up or down due to various economic reports, news
on the economy, political news, or major world events (most recently is the
large gap down from the Sept. 11 incident). This news can cause many
individual issues to gap with the market. Many big name stocks move very
closely with the market. Some may be in the sectors that are most affected
by the news.
Whatever the exact
reason, gaps are the result of some kind of event happening while the
market is closed. The result is the buying or selling pressure at the open
of the next day, which will make the stock open at a different price than
where it closed. Why are they important? This sudden move by a stock, the
sudden change in demand, is often the beginning of a major move. They are
swing trading strategies that capitalize on entering after a gap, and guerrilla
tactics that capitalize on one or two day moves after a gap.
Here are some concepts
and general rules about gaps. First, we generally never buy a large gap up
at the open or sell short a large gap down at the open. When market makers
have the chance, they will often exaggerate the gap. Also, large gaps are
already extended, making the play risky. We tend to "fade" the
gap initially, if played at all. Fading means to play the stock to come
back in to where it was. Fading a large gap up would be to go short the
stock as it trades down after a large gap up.
After the initial
move, the charts must be looked at along with the amount of the gap, and
the share price of the stock. Small gap ups that gap over resistance can be
watched for long entries. Large gap ups that gap into resistance can be
watched for short entries. What is "large" or "small"
and what is resistance is all a matter of chart reading and interpretation,
but there are some rules we will be looking at.
Small gap downs that gap
under support can be watched for short entries. Large gap downs that gap
above support can be watched for long entries. What is "large" or
"small" and what is resistance is all a matter of chart reading
and interpretation, and again, there are some rules we will be looking at.
The concept of gaps is
a very difficult one for most traders, even those with considerable
experience. They are a strategy all by themselves, and are part of many
other strategies. We will next look at a few examples. While this cannot
serve to fully educate you on the topic, it can get you started thinking
correctly about a big part of the trading day: the opening.
...Trading gaps Part 2