Do Big Gaps Mean Big Trouble for Stocks?
Everyone who owns a stock lives for the moment when they wake up and find out that there stock has opened a point or two (or several) beyond the previous day’s close. In the same way that little children are often led to believe in a tooth fairy, stock traders are no less appreciative of the “gap fairy” that causes stocks to move overnight while they sleep.
But is this “gap fairy” so benevolent after all? Certainly, while no one minds owning a stock that gaps up by 2%, 5%, 10% or more, deciding what to do after that stock has made its eye-popping gap move can be tricky. Do you hold on for potential follow-through gains? Or do you sell immediately, grateful for the quick gains and wary of overstaying your welcome?
Our research into stocks that gap up by 10% or more may surprise you. We found, after analyzing thousands and thousands of simulated stock trades between 1995 and 2007, that stocks that gap up by 10% or more actually underperformed the average stock in one-day, two-day and one-week time frames.
Gap ups typically represent one of two things–though both can be present at the same time in many instances. Gap ups tend to signify an exhaustive move higher, when those most desperate to own a stock are willing to pay a dramatically higher price for that stock, a price that was significantly higher than it was as recently as the previous close.
Why would investors suddenly decide to own a stock almost regardless of how much its price has run up in a short period of time? Beyond the same “momentum trap” that convinced mortgage borrowers around the country to borrow to buy more house than they could afford because they were convinced that house prices would only continue to climb, there is the role of the news. More often than not, when a stock makes a major gap up, it is doing so on the basis of investors overreacting to a news report.
It is worth pointing out however, that these people who are reacting to the news report are late. People who already suspected the information that would eventually become news were already long the stock BEFORE it made its gap up. In fact, they are often the ones selling to those who are buying AFTER the stock gapped up.
Click here to read our research into stocks that have gapped up by 10% or more.
One important caveat to betting against stocks that have gapped up by 10% or more is that those stocks be weak stocks, trading below their 200-day moving average. We see no reason to bet against strong stocks and no reason to bet in favor of weak stocks. By using the 200-day moving average as a general filter to separate strong stocks from weak stocks, we increase the odds that the stocks we bet against, for example, are truly the sort of weak stocks that are likely to underperform in the next five days.
All three of the stocks in today’s discussion have Short Term PowerRatings of 3 or less. This rating means that these stocks belong to that class of stocks that is only likely to achieve 90% of the S&P 500’s gains over the next five days. While these stocks may not yet be ready to be shorted (watch to see if they appear on our Short Term PowerRatings Downgrades list as 1 or 2 stocks in the near future), they certainly represent the kind of stocks that traders–especially long side traders–should avoid for the time being.
In addition to the PowerRatings charts provide below, I have also listed the 2-period RSI values for each stock as another measurement of how oversold or overbought these stocks are.
Dendreon Corporation [DNDN]. Short Term PowerRating 3. RSI(2) 93.30
Fremont General Corporation
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FMT |
Quote |
Chart |
News |
PowerRating). Short Term PowerRating 2. RSI(2) 87.68
Thornburg Mortgage Inc.
(
TMA |
Quote |
Chart |
News |
PowerRating). Short Term PowerRating 3. RSI(2) 81.43
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David Penn is Senior Editor at PowerRatings.net.