Sometimes news drives stocks in the pre-market. Other times, it’s just normal price action (think LMND the last few days).
Statistically, stocks fill the gap they create rather quickly.
But there are those times when it keeps on going…
Which creates an interesting setup in the future.
Today’s lesson is all about GAPS.
- What are they?
- How do they work?
- How can we use the information to profit?
I’ll be addressing those questions and more. Once you understand how gaps work and how to profit off them, it will open you up to a whole new world of trading opportunities.
The first question any of us should ask is what defines a gap.
Gaps occur quite often. Some of them are tiny, others quite large. They happen on everything from stocks to indexes to currencies.
Crazy enough, over 70% of all gaps in the SPY S&P 500 ETF fill that same day!
But, if you tried to trade these shooting for the fill, you’d lose money over time.
The reason – your wins wouldn’t be as big as your losses.
Big gaps tend to come off earnings or major news announcements. Buyers or sellers can’t wait for the main market hours. They feel their best position is in the pre and post markets.
Once these players establish positions, they like to defend them, the same as any other support or resistance level.
Here’s what makes certain gaps more tradable than others.
Size and distance
Larger gaps attract far more attention than small gaps. Looking at the following chart of the SPY, the blue boxes highlight gaps far more obvious than ones you would see in the orange box.
Bigger gaps tend to provide stronger support or resistance than smaller gaps. And, as the stock trades away from the gap, that also strengthens its performance. However, there is a diminishing return on both as you get bigger or longer.
Let me point out the obvious – gaps occur on the daily chart. You can look at it from any timeframe you want. But, they form on the daily timeframe.
So, the trades need to take that into consideration.
If I want to use these levels intraday, I need to realize they won’t always stop price to the penny. Quite often, it breaks through or falls short on either side of the actual gap.
On the flip side, gaps only act as one component of a trade. Using this as the only reason to take a trade can work. But, I add a lot of risk doing that.
Instead, I like to use these levels in context of the stock and the overall market.
And crazy enough, when a stock jumps over the level (gaps over/under a gap), the original gap still works!
Let’s go back to the Tesla chart to illustrate this point.
When Tesla fell with the rest of the market, it left a huge gap open around $900. That’s a great spot since it’s a large, round number.
The first blue box on the left contains the first time the stock rose to meet the gap. Once it hit, price reversed lower by $30-$40. With a $900 stock, that’s a 3.3%-4.4% decline, which is certainly tradeable.
In the next box, you can see how Tesla jumped the gap. Coming back into the same level, the stock found support before it made its next huge move higher.
Here’s another example with Dave & Busters (PLAY).
While the stock got a big reaction off the gap fill, it only lasted a couple of days.
That’s the biggest question mark around these trades and the last component I want to discuss.
How much of a reaction to expect
The amount of reaction comes from the bigger picture – taking a step back and looking at the trade in context.
What would make a gap last longer than others?
The same things that make my TPS setups work apply here as well: strong trends, overall market health, squeezes, and consolidation patterns.
Since these gaps come off the daily chart, I look at them as swing trades for at least a day or so. Using them intraday is trickier, and not as much my style.
However, I will use the intraday charts for my entry to get the best price possible.
Rolling it into a larger strategy
Most traders use gaps as one component of their overall strategy, and it’s how I employ them.
As you gain experience, your book of trade ideas will grow, giving you choices for a variety of market conditions.
In Weekly Money Multiplier, I share my experiences and ideas with members – things I’ve learned on my way to becoming a multi-millionaire trader.
Each little niche and idea adds another page to the trading library.
Come check out my upcoming webinar and see what you’ve been missing.