How One Pro Trades Very Large Gaps

01/22/2013 6:00 am EST

Focus: STRATEGIES

Steven Spencer

Partner, SMB Capital

Steven Spencer of SMB Capital details what he looks for in a setup to trade very large moves in the stocks that he follows.

Whenever I write a piece like this, a fear enters my mind that I will eventually “arb” myself out of the market. Last week, INFY had very large gap higher. Recently, I did a webinar that addressed this trading scenario from a day and swing trading perspective. I also posted this video on how to trade “Very Large Gaps”.

My view on these trades is that when there is a huge change in price that isn’t rejected early in the trading day, the stock will continue to trend in the direction of the gap (or at least move sideways). The question becomes how do you define a “huge change” in price? Here are a couple of things for you to consider. What does the weekly chart look like? Is the gap greater than 10%? A break in a weekly trend and a gap higher than 10% is a large shift. A gap above 20% is even better.

Here are the two relevant charts from INFY last week. The key takeaways from the lower time frame chart is that there was an opening drive above the pre-market range. After pulling back in the late morning, there was a nice horizontal consolidation in the middle of the day’s range before a new uptrend began. That consolidation above 51.50 was a chance to nibble on the long side. Based on the way I measure “legs” intra-day, that second uptrend should get to 53.25-53.50. A close above 52.50 certainly warrants a swing position (it closed at 52.20).

chart
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The important aspect of the weekly chart is the break of a major downtrend. If you want to see some other good examples check out ANF and GMCR. I mentioned CREE in my last webinar as another possible candidate for a large move if it were gap above its weekly downtrend.

chart
Click to Enlarge

So my focus on these setups are capturing moves in the direction of the gap. I understand from an intra-day perspective there are opportunities to capture counter trend trades. I don’t talk or tweet about them as it is harmful to our trading desk. Developing traders have a very strong desire to fade trends. If I were a neuroscientist, I would do the research on exactly why this is the case. But I’m pretty sure people’s brains are wired to want to fade. And the way SMB combats this wiring is to constantly drill following the trend into their heads.

By Steven Spencer, Co-Founder, SMB Capital

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