Gap Trading

By: David S. Nassar

With the increasingly volatile markets recently, many issues indicate supply/demand imbalances
at the open. These imbalances present themselves as what are known as gaps. Listed stock
gaps are created by order imbalances before the open, and OTC gaps occur when market
participants of the Nasdaq indicate interest for stocks in terms of opening price quotes.
News is generally the catalyst that fuels these imbalances, and news comes in a variety of forms,
such as macro economic news (FOMC meeting, for example), fruition of events from the
economic calendar, or stock-specific news, like earnings announcements, ratings changes, etc.
Regarding market reaction to news, when buying interest exceeds selling interest, the gaps are
obviously going to be to the upside, and visa versa. What is not as obvious is the level at which a
stock will open, as well as the risks associated with gap exposure.
A few years back, these levels were often determined by large off floor markets, the most
prominent being Instinet. Instinet was the first pre-market trading medium, and was a purely
institutional tool, hence its name. Today, with public acceptance of many other active electronic
communication networks (ECNs), pre and post mark et trading has a much greater number of
participants, due to the representational influx of the public interests. In reality, although the
public has access to this market, pre-market price levels are still most heavily influenced by
market makers stock bids or offers put forth at price levels above or below the previous days
closing prices (when price imbalances appear in their automated 24-hour trading systems).
Because many of these are market on open orders, market makers have an incentive to open a
stock at extreme levels directly correlated to the imbalance. Simply stated, this means that if an
imbalance falls onto the demand side, and a given issue is going to open with strength, market
makers are incented to open the stock as high as possible, while filling the market orders at the
open. This gives the market maker the legal opportunity to sell stock from their inventories, or
short stock to buyers who are willing to buy at the market, which means that they have no price
protection, as they would by specifying a limit price (using a limit order).
It has been said that, in bull markets, yesterdays highs are todays lows, but often, in the case
of gap openings, the opening prints mark the highs of the day. Because most members of the
public trade only the bullish long side of the market, many unsuspecting amateur traders trade
into gap openings, into these very high points. Its important to explore situations when a gap will
not hold and close, or when they do hold and follow through. This is perhaps the strongest
indication of the immediate post-opening trend for these gapping stocks. In the example of
bullish gaps, stocks that fail to meet the levels of the gap opening have a greater propensity to
retrace and close much of the opening gap, as opposed to the closing print from the prior days
trading. Conversely, stocks that remain strong and trade to new highs after the open will have a
greater propensity to follow through and trend higher. While this is not to be interpreted too
literally, and there are other indicators to monitor (such as indicie strength, sector strength, etc.),
it is the strongest single indication of how a stock will trade following a gap opening. In the
example of bearish gaps, as a rule, the opposite is also true. Stocks that hold a price level after
gapping down will often close the gap and trade higher, while stocks that find new lows after a
gap tend to follow through and trend lower.
In either case (bullish or bearish gaps), it is important to study the impact that gaps have on
stocks after the open. The components and considerations I have found to be most important
when gap trading are:

Charged Stocks/Sectors
Volume and Volatility

Chaotic and Overactive

High Risk (Elasticity)

Charged Stocks/Sectors
A stock or sector becomes charged due to volatility. Once a sector is in the public eye, I think of
the component stocks as being charged, and will, therefore, trade with wider price ranges.
When this occurs, obviously the stocks volume stock will be heightened and there will be a
tremendous price range from trading session to trading session (either to the upside or
downside). In the absence of actual trade activity, Nasdaq Market Makers will predict price
pattern changes slightly before or immediately after an event occurs. They will bid stock higher or
lower based on their predictions of the imbalance that will occur, and price these issues
accordingly. Once a major stock within a sector experiences negative or positive news, it can
charge an entire sector. The chart in figure 1.1 shows INTC gapping down after negative news
on inventories. This news (and its effect on Intel) caused the entire Philadelphia semi-conductor
index (SOX) to became charged and volatile immediately after. As you can see from the chart,
INTC did not hold its levels after the first gap, and followed through by trending lower.
The first clues that a stock is a potential candidate for gapping is an increase in volume over its
normal daily average. Often the increase in volume will be seen before the news is known. This
is an indication that news is leaking into the market, and illustrates the clich, stocks tell there
own stories ahead of news. Remember, the biggest trading houses often have strong
indications of sector and stock strength/weakness before the media, therefore, when increases in
daily volume accompanied by directional bias are seen in the absence of news, a gap is generally
not far behind.

Figure 1.1

Volume and Volatility

I choose to track volume by knowing the average daily volume traded by a stock or sector, and more
importantly, where the issues key price levels are. Volume is the best indication I have ever used when
sectors or stocks move closer to key levels (support or resistance). As a day trader, watching the ticker or
tape is an excellent method of monitoring changing volume for short-term intra day trades. If the ticker is
moving rapidly, you are seeing an increase in volume. It is that simple. Such conditions typically signal the
setup of a Vertical Spread (VS) Situation. A high VS indicates a rapidly changing price pattern. A trader
should seek to lead the market; to buy or sell as ranges widen. A slower moving issue with a tight
Horizontal Spread (HS), where the spread between the bid and ask is tight, (less than 5 cents) will not
require leading. In a low HS spread stock, a trader can easily lift offers or hit bids or even buy bids
and sell offers during tight price range situations. As volume increases in the short term, the less rapid
prices change, but the greater chance of sustained price change over time, hence representing a trend
formation pattern over a series of days. In order to spot volume indications that my lead to gaps, a macro
view of volume and the market itself is more useful. Again, refer to figure 1.1, and notice the dramatic
increase in the stocks volume over the course of days. But within intra-day moves, this condition of
volume will change, and, once the stock starts to move, it will have the greatest movement on the least
volume. For example, when stocks are growing weaker, panic and fear are heightened, and, as a result,
fewer buyers are coming forward. Therefore, as buyers dissipate in the market, stocks fall harder (with a
wider range) before new support levels are found. Once support levels are found, the volume builds
dramatically as the number of buyers remains strong at support levels, buying huge volumes while sellers
are still in the market. It is at these levels that the true battle between bulls and bears takes place. The
battles are illustrated through heavy buying and selling, indicating stalemated small price movement,
unresolved until one side gains control over the other. Whether bullish or bearish, once a clear imbalance
is revealed, volume tends to dry up as market participants amass on one side of the supply or demand
equation. For example, if the bulls gain control at a key support level, buyers will exceed sellers and, in the
absence of sellers, stock will trade higher on less volume, as buyers lift thin offers at each price level. The
lesson to be learned is that volume indicates where the battles are fought between bulls and bears, but once
a dominate bias is reveled, the stock will move the most on lighter volume, compared to the volume where
battles are fought at support and resistance levels. Gaps are the ultimate example of this (where no volume
exists, but extreme price change does). Once this gapping action begins, chaos is not far behind.
Chaotic and Over reactive
Chaos is at its climax when stocks have no established support or resistance levels. For
example, if an issue is not well supported until a stock trades 20 points lower, then volatility will
be extreme. When these conditions exist, it is strictly a day trading only environment, where
taking overnight positions is an unwise risk. Tighter risk tolerance rules this climate. Day trading
methodology is much more risk averse and profitable if followed with discipline. Remember,
volatility can also be defined as chaos, and, therefore you can throw your technical tools and
indicators out the window. A trader who wants to trade in this climate must take a micro view of
the stock, taking small incremental profits and losses versus trying to trade the overall trend.
Please note that gaps can often reveal the beginning of such a trend, but because of the chaos
associated with wild volatility within the trend, position trading is subject to too much whipsaw
risk (see High Risk below). The position trader in these climates can count on nothing being
small, not profits or loses. When a large relative range of movement occurs in a stock through
increased volume and volatility, the chances of gap opening increase significantly with risk. For
example, you may notice that Ciena (CIEN) has moved in a price range from 85 (support) to 115
(resistance) for the last 5 days. This means that the stock may move from one level to another
over a period of time and then reverse the move, only to repeat it again. Or the stock trades
down to a certain price level, finding support, and beginning to consistently move upward, which
reveals the beginning of an upward trend. These patterns are so chaotic that position trading
under such conditions is more associated with gambling. See figure 1.2

Figure 1.2
High Risk
A trader in these situations must have a much greater risk tolerance going into the trade and
should understand that these price fluctuations are part of the equation. Otherwise, the trader
who does not recognize this volatile range as being normal will constantly employ discipline at
the wrong time and be whipsawed out of trades, taking many loses. If youre going to trade
these types of stocks, you need to employ greater risk tolerance and certainly you need clarity of
the bigger picture or the broader price patterns, before considering adding these big-range stocks
to your interest list. It is also important to dramatically lower your size in these trades, since the
range in price offsets the trade size needed for profit. In short, it is like a hurricane, when youre
in its midst, it is only chaos and you cant determine from where the wind is blowing, but if you
can step away far enough (broader view) you can see the overall direction. Trade these issues
accordingly, or just decide to stay away altogether! These characteristics are precursors to the
Gap Trade, since these issues have the greatest propensity to gap open. If an overnight
position is entertained, certain questions must be addressed first.
To Trade or Not to Trade, That is the Question!
Do you have the account size to absorb the potential gap?
Do you have the temperament or risk tolerance?
Are you In the Money, and wish to accept additional risk for additional reward?
Is it really worth it?
Do you have clarity and confidence that you see the Gap coming?
Did you day trade this stock the entire day prior to the anticipated Gap?
If you answered No to any of these questions, dont even think about it!
If you answered Yes to ALL of these questions

Consider that with volatile price pattern movements during the day, stocks will tend to overreact
or overtrade, while pushing prices artificially higher or lower during the day. This sets up the
correction for the next trading session where market makers will often gap the stocks price to
what they feel is equilibrium, or where they want to trade the stock for the open the next day.
Remember, the first gap that sets the stock in motion is due to unforeseeable news and, as a
rule, is not predictable. The gaps that may occur after the trading day following the original gap
may arise for some of the following reasons.

Short Squeezes (Hook Closes)

Profit taking (Hook Closes)
Additional News such as Earnings releases
S&P Futures Volatility

Short Squeezes
Short squeezes and Profit Taking are the most common reasons stock volume will tend to build to
above-average levels into the close, causing what is called a Hook close. The short squeeze is
simply a term explaining when a stock is on a downtrend for the day and Market Makers suspect
there may be short sellers in the market as a whole. The squeeze occurs and so does the Hook
when the professionals begin to buy the stock rapidly into the close, causing the prices to rise
swiftly, causing the short sellers to cover in panic. See figure 1.3

Figure 1.3
Profit-Taking
Profit-taking generally occurs when a stock is in a rising trend for the day, and the stock shows a
weak close, accompanied by high volume as Long traders begin to sell the stock to take a profit.
See figure 1.4

Figure 1.4
A Note on Profits and Gap TradingIf I am not in a profitable situation from day trading the stock,
I will not enter the overnight Gap trade. It is best to stand aside, and trade the open the following
day if , and after, the issue gaps open. If, after profitably day trading the issue, you are
contemplating taking the overnight position, then that is a risk/reward question only you can
answer. Never hold a negative position overnight hoping the stock will come back. Such a
tactic isnt trading; its gambling. Only pursue an overnight position with purpose and confidence.
Never turn a day trade into an overnight position because things didnt go your way.
Earnings
Earnings are perhaps the most significant factor impacting gap trades, since earnings have such
a significant influence on stocks and sectors. The message regarding earnings is simple. The
market punishes missed earnings to a much greater degree than it rewards earnings that meet
estimates. Many companies meet expectations and still get hammered the day after earnings are
reported because most positive earnings are built into the stocks price over the days prior to the
report, unless there is a true surprise. For this reason, stocks have a greater propensity to fall
when companies only meet expectations. When expectations are missed, the downside bias is
dramatic. Therefore, I rarely take an overnight position involving a company that is reporting
earnings after the close. If I do, my natural bias is to be short, especially in this volatile market
environment. Because so many stocks see upside bias the days prior to an earnings report, I
prefer to take a long position during this period, sell into the news and wait for the outcome. See
figure 1.5 for an example of what companies experience when expectations are missed.

Figure 1.5
S&P Futures
S&P Futures are important to consider when taking an overnight gap trade. I like to look at the
futures into the days close to spot a correlation relative to the position I plan to take for the
overnight gap trade. For example, if the futures are exhibiting strength into the close, and all
other factors and questions are right, I will go long into the close. If the futures are weak into the
close, and I suspect a short play opportunity, I will consider this in my favor as well. A trader
must have clarity when taking an overnight position for a gap trade. But perhaps the most
significant piece information a trader can consider is the feel one gains by day trading the stock
during the day. By day trading the stock the entire day, tick for tick, trade for trade, you cant help
but build the needed intuition to form the decision as to weather or not to engage in the overnight
gap trade.
A final word
Remember, gap trading is risky business, and the professionals who mark stocks up or down
prior to the open have a vested interest in doing so. If you were a market maker who made your
living buying and selling stocks from the public, while providing liquidity to the market, where
would you open a stock with poor news, knowing you would be receiving market on open
orders? You would open them as low as possible, (where you felt the stock was well supported).
This is known as buying weakness. Conversely, with strong news on an issue, knowing you
would be selling at the open, where would you open the stock? As a market maker, youd open
that stock at as high a level as possible (to enable you to short stock to buyers at would-be
resistance levels). This is referred to as selling strength. This is why gaps have a greater
propensity to close immediately after the open. If they continue to follow-through in the direction
of the gap, then the indication is strong the trend will continue and the gap will widen. These
rules should serve as a guide, but shouldnt be traded with absolute literal indiscretion. Only
monitoring and confirming indicators will form an overall bias.

Remember, trading is not gambling. Successful traders use a combination of intuition,

technology, and decision-support tools such as the tape, Level II screen, price levels and charts
to make an informed decision. The statistical advantage is gained by following your discipline
while employing some of these techniques.