This is in response to a comment that Jon left the other day about how I deal with gaps (sorry for the delay Jon). The title is meant to be a joke. I didn’t think I despised gaps but Jon’s question really made me think about why I feel how I do about gaps. After that reflection I’m starting to think that maybe I do despise them. :-) Anyway, I hope what’s below is a decent answer to his questions…

Jon: It seems like a lot of your trading tactics are to avoid carrying a position through a gap.

Me: Well I guess that depends on what time frame I’m trading. Much of what you read on this blog is about what I do with my “active trading” account. Last May I switched from swing trading to strictly day trading. I define day trading as not holding stocks overnight. So I guess by default your observation is correct but avoiding gaps wasn’t my primary (or even secondary) reason for switching to day trading. As I said back in May (read that post for more detail) the switch was primarily to allow me greater flexibility and to allow me to trade during the gap-filled earnings season that I used to avoid when I was swing trading. As it happens, greater buying power, an exponentially better position sizing model and yes, avoiding gaps were nice side benefits.

Back when I was swing trading I had no problem holding stocks overnight, and therefore basically inviting gaps. However, I would never initiate a position if I thought a gap was imminent — like just ahead of an earnings report. I might hold through an earnings report depending on how much profit I had in the stock ahead of the report. But 99% of the time I’d rather just get out.

For my long term account (IRA) I will hold through earnings reports but I won’t initiate a position right before earnings.

Jon: Do you think that there are certain environments or circumstances where you can anticipate and exploit gapping, or do you think that the risk vs. reward will always be too poor?

Me: Nope, the risk/reward is unknown, IMHO. Take earnings for example, even if I thought I had a clue what company X was going to report, I’d still have to know how the market would react to those numbers. Then I’d need to have some clue about guidance and anything that might come out during the conference call. I know some people (Duru) like to do certain options plays around likely gap situations (earnings, FDA decisions, court decisions, etc.) but that game just isn’t for me.

Jon: Also, if you have had traumatic experiences with gapping, would you mind talking about them?

Me: The worst by far was when the market re-opened after 9/11. Besides that the only situation that I can remember was when OSIP gapped up 20 points against my short position in December 2004. Note that I felt the same about gaps before these two events as I do now.

Jon: I’ve been reading your blog for over a year and I’ve always wondered why you seem to be gun-shy of gaps.

Me: If we’re talking about swing trading it really comes down to the fact that gaps usually adversely affect my risk/reward and cause me to (quickly) change my plans. Here are some examples (I’ll just use longs for examples but the same applies to shorts just ‘flip everything over’):

  • I want to buy XYZ at 25 with a stop at 24.25 based on where I see support & resistance on the chart. I see a potential profit target at 27. The stock gaps open to 25.75 b/c of the futures were up for some reason unrelated to XYZ. Now, right at the open, my risk/reward is drastically changed and I’ve got to decide how to proceed. This kind of thing usually happens with several stocks that I want to buy at the same time. So now I’ve got a lot of decisions to make during the hectic early minutes of trading. There’s the tricky decision to chase or wait to see if the gap gets faded. Getting ‘chopped up’ in situations like this is what led me to post Rule #1 on my monitor. I never liked situations like this but I learned how to deal with them.
  • I’m already long XYZ and it gaps up halfway to my profit target. The gap is just due to the indices gapping up, not due to XYZ specific news. While this seems like a great situation if is often frustrating for me. Do I snatch the quick profit or hold on and risk the gap getting closed? There’s no perfect answer. Again, not a situation that I prefer but I dealt with it for years.
  • I’m already long XYZ and the stock gaps down below my stop. Obviously nobody (I think) likes this situation.
  • The one gapping situation that I actually don’t mind is when I want to buy a stock and it gaps down a bit. Since I usually like to buy above the previous day’s high this situation allows me to see if there’s true strength in the stock. If it can rally back above my buy point I usually really want to buy that stock.

I think my harping over the market gapping up into resistance for a few days in a row is what ‘inspired’ Jon to leave that comment. IMHO, it’s critical to identify those kind of gaps b/c they often immediately bring out sellers. It’s not that I’m trying to avoid those gaps (I avoid them by default since I don’t hold stocks overnight) but rather I’m just making sure I know where resistance is and I’m positioning myself to try to profit from how the market reacts to that resistance.