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Opening Gaps: Trade ‘Em, Fade ‘Em, Or Ignore ‘Em?

By Dave
Landry

TradingMarkets.com

 

Gaps occur on the euphoria of
eager traders rushing into (or out of) a market on the open. This euphoria
may draw in additional traders as gaps often viewed as a sign of strength
(or weakness for down gaps). However, many times opening gaps represent
reversals as these Johnny-come-lately’s  who buy (or sell for down gaps) are
the last to enter the market.  This action creates a dilemma for the trader.
Should the gap be traded? faded? or simply ignored? Below we will look at
some ideas on how to solve this dilemma.

Trade ’em

An opening gap in the direction of
the intended trade is a sign of strength (or weakness for shorts).
Therefore, when market conditions are favorable and the gap isn’t too large,
you should trade the open.

Obviously, “favorable conditions”
and “too large” can be somewhat arbitrary. In general, favorable conditions
means that the overall market and sectors are in gear. This means they are
trending strongly, or if they are not trending, are showing some signs of a
major reversal. 

“Too large” can be gauged in terms
of the volatility of the stock and the pattern (setup) being traded. A
two-point gap may be too large for a stock that barely moves two points in a
week. On the other hand, a two-point gap for a volatile stock, say one that
trades 5-10 points in a day, isn’t as significant. As far as pattern, if the
gap is near a technical level, then the trade should be ignored. For
instance, suppose you are looking to enter on a pullback. If the stock gaps
all the way to the area of where the pullback began, then you have missed
the move from the pullback to the old highs. Often, in this pattern, this is
all you get.*

Biotech Cubist Pharmaceuticals (CBST),
in mid-February 2000, provides a good example of when a gap should be
traded. Notice that the stock was in a strong uptrend and had begun to
pullback. At this time, the overall market and the biotech sector were in
strong uptrends. The gap of  3/4 point in the direction of the uptrend (a)
was within the normal volatility of the stock (at this time the average
daily range of this stock was 2-3 points). Further, the gap was well below
the first potential target of the old highs (b) (refer back to the footnote
below). 

 

 

The Second Entry Option

Depending on the market conditions
(especially in choppy markets), you might want to let a stock trade for 5-15
minutes to see if the stock comes in. Then you can place your order above
the gap/intraday high for a “second entry.” This helps to avoid potential
bad trades, as gaps can often be the high or near high for the day. The
trade-off, of course, is the opportunity cost of missing a good trade if the
stock gaps and never looks back.

Fade ’em

Often, especially after a strong
trend, markets will gap to their final high. As mentioned above, this occurs
as the Johnny-come-lately’s dog pile onto a market. This is known as an
exhaustion gap and is illustrated below.  For the nimble daytrader,
this may present an opportunity to fade (go against) the market, using a
tight stop (usually right above the gap).  

 

 

4 Kids Entertainment (KIDE),
one of the poster children for bubble stocks, provides a great real world
example. The stock gaps open to its all-time high (a) as the last of those
catching Pokemon fever rush into the stock.

 

Rather than fade such a strong
trend, as a momentum swing trader, I normally use these exhaustion
gaps as an opportunity to take profits on existing positions.

Fade With The Trend

As implied above, as a momentum
player, I normally trade in the direction of the overall trend. Therefore,
I’m less likely to fade a gap (to enter new positions) unless it’s a gap
against the major trend and there is a swing trade setup.  In this case,
I’m entering a daytrade with the hopes of it becoming an early entry on a
swing trade.

For example, assuming that the
overall market is strong but shows some overnight weakness, this will cause
stocks to gap lower on the open, as the weak hands are scared out of
positions. Then if the market and the stock begins to show signs of
strength, I might look to get in as the longer-term trend resumes. This is
illustrated below.

Suppose a stock is in a strong
trend and pulls back. If it gaps down on the open (a) and then begins to
rally (b), I may consider a daytrade where I buy the stock and put in
a tight stop below the gap (a). If the stock fails, I’m out at a small loss.
If the stock continues, I might get a “head start” on a decent swing trade. 

 

 

Here’s an example in the overall
market. Notice the Nasdaq began to pull back from its free fall back in
April 2000. The index gaps open (a) which turns out to be its exact high
before its downtrend resumes.

 

Here’s an example in an individual
stock on the same day. After losing nearly 100 points, Veritas Software (VRTS)
pulls back from lows. The stock gaps higher (a), but the gap fails to hold
and the stock’s meltdown resumes.

 

 

Ignore ’em

As implied under “Trade ’em,” if
market conditions are not favorable and/or the stock gap is too large, then
the trade should be ignored. As mentioned above, “Too large” can be gauged
in terms of the stock’s normal volatility and in terms of pattern.

Here’s a real-world example. On
1/23/2001, I mentioned Lam Research (LRCX)
as a potential pullback(a) in my “Stock Outlook.” The following day the
stock gaps open over 8% (b), a somewhat extreme move, even for this volatile
stock. This gap is also near the prior highs (c). Further, although the
Nasdaq had been rallying off of its lows, technically, it was still in a
bear market and was overextended at this time. Initially, this looked like a
bad decision, as the gap held and the stock closed well above its open.
However, over the next few days the stock comes back in.

 

*When a stock rallies out of a
pullback (a) it will either take out the old highs (b)–creating a breakout
or it will stall out at this juncture–creating a potential double top.
Therefore, because you don’t know which one it will be until after-the-fact,
it’s a good idea to take partial profits as the old highs (b) are
approached.

 

 

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