How to Successfully Trade Stock Gaps
For those who know how to properly identify the correct positions, gap trading in the stock market can be a regular and time-tested strategy for sizable gains.
A gap in a stock’s pricing is simply when the opening value of a stock is lower or higher than its previous day’s closing price. The literal “gap” between the two values is where traders can take advantage of the rise or fall of the supply or demand of the stock. If correctly traded, a gap can be an integral part of your trading strategy.
More often than not, gaps are a result of some kind of announcement or news that rallies a large movement from traders and investors. The value of these setups lies in the significant intra-day moves that occur as a result of the breaking news. It’s critical to note that gaps, whether up or down, can occur in a variety of situations, but not all of them are worth trading. Regardless of the hype surrounding an expected large movement on the opening, successful stock gap trades lie in relying on quantitative research, not speculation to set up your trades.
Since these gaps are generally news-based, the moves themselves can be very temporary and a reversion to the mean will occur more often than not. Traders using a quantitative strategy can trade the gap knowing that the stock will bounce back relatively soon. Historical analysis of the market shows that downward gaps will reverse their movement over a short-term period, and the same is true for upward gaps as well.
Let’s take a quick look at what a gap in a stock’s price looks like. The following chart shows the up-gap on May 9th of SodaStream International Ltd.’s (NASDAQ: SODA) opening. While a gap might have been preceded by positive earnings results or some other optimistic news, the gap is more often than not a late push from retail investors to buy as a reactionary response. The professional traders and investors who did their homework have already locked in their positions the night before based on quantitative-analysis, not emotion.
Conversely, a down-gap in a stock’s price is likewise usually linked to some news event, but this time tied to negative earnings or for example some kind of legal action against the company. Retail traders are panicking and dumping their shares after the majority of informed trading has occurred. The chart below shows the down-gap on May 8th of The Scotts Miracle-Gro Company’s (NYSE: SMG) opening.
Instead of relying on the unsubstantiated claims, the key for traders looking to capitalize on these price gaps is the knowing the historical performance of a stock in order to determine the proper setup and to monitor the patterns in its movement. Looking at the average profit/loss percentages, trading volume, and other objective indicators grants us the opportunity to fully analyze whether the potential trade can be profitable.
Gap trading is only one of a myriad of ways to secure gains with a statistical, historically-backed strategy. It can be an incredibly successful one if the proper research is done beforehand to ground your trading in data, not speculation.