Mind the gap

Price gaps occur when the market is closed overnight or over weekends. When the market re-opens, the first trade is considered the sum of all expectation at the time, in which after market news is factored into the opening auction.

Many textbooks describe an opening gap as being a bullish sign that the buyers are out in force. This only works if you know where you are in the price trend, and as no one knows what the future holds in price movement, then we can never know where we are in the trend. This is an observation lost on traders who insist on holding a losing position and believing it will return to profit. The flaw with this type of trading is if a position does return to profit, the trader has now been rewarded for bad behaviour and will continue to hold future losing positions expecting the same outcome. It’s not until one day the position loss becomes an account loss.

Gaps can be described as a bullish gap open, or a continuation gap and an exhaustion gap. By using  chart analysis, these market events can be tested. Depending on your time frame as a trader, the results can be put to work to use as an entry tool to open a position and/or capture profits.

For the longer-term investor, the end of a trend is often the gap down on open in larger time charts, than just a daily view that most traders and investors use. These events often occur in a weekly chart time frame.

On the left, ANZ posted a weekly gap down in May 2015 that ended six years of gains.

The Weekly gap in FMG during March 2014 lead the price down to historic lows of December 2016.

On the right, the daily gap down ended eight years of gains in Credit Corp CCP.
The chart of CCP also displayed a gap down on open on 2 February, which was followed by a 16% decline, until the primary trend resumed approx. four months later.

A short-term view of gaps as a trading opportunity

For the short-term traders, gaps can be used a little differently and can offer an intimate trading strategy. By 'short-term' I refer to traders that use intraday strategies of up to one or two days holding time.

The opening price gap can provide some excellent trading opportunities for the nimble short-term trader on both the long and short side of the market.

However, it does require some reverse thinking and action. From a textbook point of view, when a stock gap is higher on the open it’s a sign of strength and buyers are in control. However, we must consider the different type of market participants, some being long-term holders and others only trading for quick profits.

In Example 1 (below) we can see from the close trading period following (1) gapped open and sold back into the first range. The following trading period gapped open lower and traded back higher.

When taking a closer look at the detail in price charts, this phenomenon is a regular occurrence. In fact. an average of 30% of daily bars can offer this type of short term “doing the opposite trading opportunity.”  In Example 1, the fluidity of movement can be seen from the high close of the first bar the gap open higher of the second bar and the follow on gap down of the 3rd bar, within this bar the sellers have lost control to the buyers closing it in the top 80% of the range.

Using an intraday chart, Example 2 highlights (using a one-hour timeframe) the Gap open sell and the Gap open buy, which offer short-term trading opportunities for the nimble intraday trader. Correct position sizing and stop losses must be used with this type of strategy.

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