Basic Gap Trading Strategies

10/13/2009 12:01 am EST

Focus: STRATEGIES

A “gap” is a term used to describe the condition when a stock opens at a higher or lower price than where it closed the prior day. There may be a gap that is left in the daily chart between the prior day’s closing price and the current day’s opening price when the stock gaps away from the last bar. There may also be “congestion” as it gaps into the prior bar. 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 New York 4:00 pm closing price to the current day’s 9:30 am opening price. These times are all EST. 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 8:00 pm, and in pre-market starting at 8:00 am, but this is currently not considered “normal” market hours.

For example, stock XYZ closes at 4:00 pm EST at $37.00. It trades in aftermarket hours up to $38.00. The next day at 8:00 am EST, it starts trading at $38.50 and trades up to $39.50. By 9:30, the stock is all the way back down to $37.10. The gap, as we measure it, is only 10 cents, the difference between $37.00 and $37.10. All those post- and pre-market trades do not matter. The stock traded, and people made and lost money, but the gap itself is measured in that way.

What causes gaps? Usually, they are 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, and 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 (like the large gap down from the 9-11 incident, or the gap up when Saddam Hussein was captured). 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. Gaps are always possible sources of plays. A gap leaves a void on the chart where no one was able to trade. This often has the affect of trapping people in positions that will need to be handled that trading day. We look at gaps as being professional, novice, or continuation. There is a concept that says “Gaps are always filled.” Filling the gap means to trade back to the prior closing price, which erases the affect of the gap at that moment in time. While gaps are often filled, they do not have to be.

By Avery Meizner of Pristine.com

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