Turning Stock Gaps into Winning Trades

I have been an intraday gap trader in the equities market since 2005. My setups are formatted off the direction of the gap. The term “gap” is used to describe the condition when a stock opens at higher or lower price than it closed the prior day. Gaps create voids that are left in the daily chart by leaving an empty space from the prior day’s close to the current day’s open. What causes gaps? Most of the time gaps are created from a news-driven event.

How do I trade gaps? First of all, not all gaps are tradable. However, when I do trade a gap I look for a gap that has been produced by a news driven event. The news generates a shock or surprise which then causes the gap. If the gap has shock value where it is affecting the previous investors or traders that presently hold the stock then it has the potential of setting up a trade. Gaps are important because they bring a sudden change in supply or demand which can bring about a very large move intraday.

For example, below is the daily chart of ^ADCT^ on 8/12/09, showing a gap up at the open.

This gap created a shift in the supply and demand of the stock’s shares which then produced a large up move intraday. The shift occurred with the shock of the gap that trapped the bearish investors/traders that were short on the downside. The gap trapped the bears causing them to cover at the open. Box A on the chart demonstrates where the bears were trapped.

The chart below shows how I would look to play ADCT based off the gap above on the daily chart.

I personally like the 5-minute chart for intraday entries because they can provide low risk entries. The two bar pullback off the five minute chart to support over the first green bar at $8.26 is where I would look to buy. I would then place an intraday stop loss at just .01 below the low of the entry bar at $8.15, thereby, risking only .11 cents on the trade. I would then trail this trade up to $9.00 a share for a profit of .74 cents. This trade would have yielded 6.72 risk units of reward based upon my previous risk amount on the trade.

An important point to remember when trading is that you are trading against other people. The gap can give you an edge. Keep in mind that any gap for any reason can move in either direction so risk accordingly.

Troy Peterson is a professional equities trader and blogger who focuses on trading the imbalances in the market created by gaps. He received his Bachelor’s degree at Vanguard University of Southern California and is the founder and host of Trader Talk on blogtalkradio.com/tradertalk. You can also find him at www.gapedgetrading.com.

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