David Nassar has written a good article about how to trade stocks that gap. He argues that if a gap is more than 5% the more will continue in the direction of the gap. He also examines the mindset (psychology) of traders who play gaps:
A gap is a term used by technicians to describe a significant jump in price as the markets open when compared to the previous closing price.Gaps seem to become the emotional catalyst for many traders who seem to believe that, "If I sell a gap higher and then buy the stock back as the gap is closed, I am just as smart as a trader who was long prior to the gap." This reasoning does hold merit if, for example, shares are (a) in a downtrend and (b) shares gap less than 5 percent against the prevailing trend and into resistance.
Of course, if shares gap more than 5 percent, all bets are off and traders need to understand the path of least resistance may very well have changed and traders selling shares that have opened 5 percent higher must understand "There is a reason shares are 5 percent higher -- the market is telling you something. Please listen."
Traders love rational stories to explain price action, and these fanciful headlines are usually sprinkled with both fundamental and technical themes.
For what it's worth, I've never been a fan of fading gaps. I'd much rather look for an entry to go in the direction of the gap.
(Thanks to Duru for forwarding the article to me.)
I primarily trade the index futures, so I don't how difficult it would be to apply for stock traders.
But I track the statistics around the opening gaps to help in trading them. Sometimes 5% means gap-n-go, sometimes not.
In addition to knowing the recent average gap and the percentage of closers and runners by gap size, I know how much the gap runs before it closes.
I also take the overnight high/low into consideration.
None of it is a guarantee of course. But each day I can play it knowing my probabilities and possibilities.
Much more comfortable than just "go with 5% and fade below 5%" IMHO.
Great post Mike. I had always heard that gaps will be filled eventually. I didn't like that philosophy myself. And to here someone's observation that a gap more than 5% is probably not going to be filled any time soon is refreshing.
Interesting stuff. Gaps come and go, but trends will always be with us.