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By Dave Landry
Gaps occur on the euphoria of eager traders rushing into (or out of) a market on
the open. This euphoria may draw in additional traders as gaps often viewed as a
sign of strength (or weakness for down gaps). However, many times opening
gaps represent reversals as these Johnny-come-lately's who buy (or sell for
down gaps) are the last to enter the market. This action creates a dilemma for
the trader. Should the gap be traded? faded? or simply ignored? Below we will
look at some ideas on how to solve this dilemma.
Trade 'em
An opening gap in the direction of the intended trade is a sign of strength (or
weakness for shorts). Therefore, when market conditions are favorable and the
gap isn't too large, you should trade the open.
"Too large" can be gauged in terms of the volatility of the stock and the pattern
(setup) being traded. A two-point gap may be too large for a stock that barely
moves two points in a week. On the other hand, a two-point gap for a volatile
stock, say one that trades 5-10 points in a day, isn't as significant. As far as
pattern, if the gap is near a technical level, then the trade should be ignored. For
instance, suppose you are looking to enter on a pullback. If the stock gaps all the
way to the area of where the pullback began, then you have missed the move
from the pullback to the old highs. Often, in this pattern, this is all you get.*
Fade 'em
Often, especially after a strong trend, markets will gap to their final high. As
mentioned above, this occurs as the Johnny-come-lately's dog pile onto a
market. This is known as an exhaustion gap and is illustrated below. For the
nimble daytrader, this may present an opportunity to fade (go against) the
market, using a tight stop (usually right above the gap).
4 Kids Entertainment (KIDE), one of the poster children for bubble stocks,
provides a great real world example. The stock gaps open to its all-time high (a)
as the last of those catching Pokemon fever rush into the stock.
Rather than fade such a strong trend, as a momentum swing trader, I normally
use these exhaustion gaps as an opportunity to take profits on existing positions.
For example, assuming that the overall market is strong but shows some
overnight weakness, this will cause stocks to gap lower on the open, as the weak
hands are scared out of positions. Then if the market and the stock begins to
show signs of strength, I might look to get in as the longer-term trend resumes.
This is illustrated below.
Suppose a stock is in a strong trend and pulls back. If it gaps down on the open
(a) and then begins to rally (b), I may consider a daytrade where I buy the stock
and put in a tight stop below the gap (a). If the stock fails, I'm out at a small loss.
If the stock continues, I might get a "head start" on a decent swing trade.
Here's an example in the overall market. Notice the Nasdaq began to pull back
from its free fall back in April 2000. The index gaps open (a) which turns out to be
its exact high before its downtrend resumes.
Here's an example in an individual stock on the same day. After losing nearly 100
points, Veritas Software (VRTS) pulls back from lows. The stock gaps higher (a),
but the gap fails to hold and the stock's meltdown resumes.
Ignore 'em
As implied under "Trade 'em," if market conditions are not favorable and/or the
stock gap is too large, then the trade should be ignored. As mentioned above,
"Too large" can be gauged in terms of the stock's normal volatility and in terms of
pattern.
Here's a real-world example. On 1/23/2001, I mentioned Lam Research (LRCX)
as a potential pullback(a) in my "Stock Outlook." The following day the stock
gaps open over 8% (b), a somewhat extreme move, even for this volatile stock.
This gap is also near the prior highs (c). Further, although the Nasdaq had been
rallying off of its lows, technically, it was still in a bear market and was
overextended at this time. Initially, this looked like a bad decision, as the gap
held and the stock closed well above its open. However, over the next few days
the stock comes back in.
*When a stock rallies out of a pullback (a) it will either take out the old highs (b)--
creating a breakout or it will stall out at this juncture--creating a potential double
top. Therefore, because you don't know which one it will be until after-the-fact, it's
a good idea to take partial profits as the old highs (b) are approached.