A gap is a break between prices on a chart that occurs when the price of a stock makes a sharp move up or down with no trading occurring in between. Stocks that "gap up" are companies that open at prices that are significantly higher than their previous closing prices, often due to after-hours news items that positively impact investor perceptions of a company's valuation. More about gap up stocks.
Trading gap-up stocks can be a profitable strategy for active, risk-tolerant investors
A gap-up stock is one that opens trading at a higher level than the previous day’s closing price. This is often signified by a sharp move with no other trading occurring before or after the gap. Investors can identify gap-up stocks during after-hours and pre-market trading. Reasons why a sock may gap up include the release of news about the stock, such as a favorable earnings report or some sort of geo-political event that may incite speculators to bid up the price of the stock.
A gap-up stock represents a significant stock trading opportunity. However, it requires the discipline to follow the trend and setting trailing stops that allow investors to exit the trade when the direction of the stock no longer supports that trend.
In this article we’ll break down gap-up stocks by defining what they are and how you can identify them. We’ll also provide an overview of gaps so that you can understand how to interpret a stock chart. We’ll also go over the most common gap trading strategies.
Why Are Gap-Up Stocks Important?
A stock that is gapping up indicates a large volume of buyers. However, what’s harder to tell is whether the gapping action is short lived or whether it will continue to become a trend. Investors who want to trade gap-up stocks can easily find them by using a stock screener. Once you identify a potential gap-up stock to trade, you should carefully study the longer term charts of the stock to see if there are clearly defined areas of support and resistance.
If you’re new to gap trading, it is important to look at stocks that are trading with a high volume (a good average volume is above 500,000 shares a day). A gap up stock is clearly represented in a candlestick pattern. A candlestick is a technical indicator that shows the opening and closing price of a stock for a specific period. The color and composition of the candlestick provide information about a stock’s direction and momentum.
How Can Investors Interpret the Significance of a Stock that is Gapping Up?
The gap in a gap-up stock is either a “full gap” or “partial gap”.
- A full gap occurs when a stock opens at a higher level than the previous session’s high.
- A partial gap occurs when a stock opens above the previous day’s closing price.
Here’s an example that illustrates the difference between a full gap and a partial gap. During the trading day, the stock of Company ABC closes at $39. However, during the day the stock was trading as high as $41. At the opening bell the next day, the stock opens at $42.50. That stock would be opening higher than both its previous close ($39) and its previous daily high ($41). This would indicate a full gap. However, if the same stock opens at $40, it will only show a partial gap. While closing above its previous closing price of $39, it did not “gap up” above the previous session’s high price of $41.
The importance of understanding the difference between a full gap and a partial gap is about supply and demand which highlights the difference in risk and potential gain. In general, full gap stocks provide a better opportunity for profit over several days.
For example, a full gap means there is usually sufficient desire to buy or sell the stock. This increased demand will be a signal to market makers that there has to be a significant price change to accommodate any orders that have to be filled. With a partial gap, demand might be such that only a small price increase above the closing price will allow buy or sell orders to be filled.
Beyond the terms full gap and partial gap, gaps generally fall into one of four categories:
- Breakaway Gaps – These are gaps that take place at the end of a pricing pattern and signal the start of a new trend. Breakaway gaps will coincide with high volume.
- Exhaustion Gaps – These are gaps that take place towards the end of a pricing pattern and represent a final attempt to set a new high or low. Exhaustion gaps will coincide with low volume.
- Common Gaps – These are gaps that cannot be placed in a price pattern. These simply represent an area where the price has gapped.
- Continuation Gaps – These gaps occur in the middle of a price pattern and signal a rush of buyers or sellers who share a common belief in the underlying stock’s future direction.
It is common for gaps to get filled in naturally. This means the stock price will move back to its original level. Because of the volatility around earnings season, this is typically a time when stocks will make large price movements.
In some cases, investors (usually individual investors) may be overly enthusiastic about a stock. In almost every case, this will result in a correction. Another reason may be due to a lack of support and resistance. Support and resistance lines are technical indicators that traders can use to set price targets. When a stock gaps up, it usually doesn’t leave behind a support or resistance line to anchor that price level. Finally, the type of price pattern can indicate whether a gap will be filled. For example, exhaustion gaps come at the end of a price pattern, making them more likely to be filled. Breakaway and continuation gaps, which are confirming the direction of a trend, are less likely to be filled.
When gaps get filled within the same trading day as they occur, the gap is said to have undergone fading. This is common during times such as earnings season.
What are Some Effective Trading Strategies for Gap-Up Stocks?
As an investment strategy, trading gaps involve stocks that have above-average volatility. This also means it entails above average risk. However, investors can trade gaps successfully (and profitably). Here are some guidelines that can help you stay away from poor gap-up stock trades.
- If the gap of a stock has started to fill, it will almost always continue in that direction. This is because the stock has no immediate support and resistance.
- Be sure you understand the type of gap you are trading. An exhaustion gap and continuation gap move in opposite directions.
- Before you take a position, be sure that the stock price has started to break in the direction you foresee. Individual investors are the ones who tend to get overly enthusiastic about a stock. This plays into the hand of institutional investors who may support the trend in order to boost their portfolios.
- The volume should be consistent with the kind of gap you are trading.
Once you are familiar with the mechanics of gaps and understanding how to look for potential gap trading opportunities, it’s time to look at some common gap trading strategies. These involve having clear rules for entering and exiting a trade. Gap trading can be risky and having the discipline to follow entry and exit points is one way for you to help minimize that risk.
For each gap up strategy, there is a short and a long trading signal. Most gap trading occurs one hour after the market opens to allow time for the stock price to settle into a range. No matter what strategy is being used, it is important to set trailing stops that provide a point where you exit the trade in case the trade starts moving in the opposite direction. For example, if you buy a stock at $50, you could set a trailing stop of 5 percent, in this case $47.50. If the stock rises to $60, you raise the stop to $55.50 (5% of $60) and keep on raising it while the price rises. The opposite would occur if you’re trying to short the same stock at $50. In this case, you would set a trailing stop at $53.50. If the price drops to $40, you would reset the stop at $42. Trailing stops will usually be tighter (smaller) for partial gap stocks as opposed to full gap stocks.
Here are the most common trading strategies for gap-up stocks. These will occur one hour after the market open (typically 10:30 A.M. EST). The same strategy is applied to either full gap or partial gap positions. These strategies also work for after-hours or pre-market trading.
- Long Position (Buy): Set a long trailing stop at two ticks (defined by the bid/ask spread) above whatever the high stock price was in the first hour of trading after the market open. The bid/ask spread is usually either one-eight or one-quarter point.
- Short Position (Sell): Set a long trailing stop at two ticks below the lowest stock price reached in the first hour of trading.
What is the Modified Trading Method?
The Modified Trading Method is an advanced version of the two strategies shown above. This method can apply to either the long or short position. The difference in this method is that instead of requiring a trader to wait until the price breaks above the high (long) or below the low (short), they trade in the middle of a price rebound. This strategy is only used on a stock that has been trading on at least 2X its average volume over the previous five days.
- Modified Trading Method Long Position (Buy): Set a long stop that is equal to the average of the open price and the high price that was set in the first hour of trading.
- Modified Trading Method Short Position (Sell): Set a long stop that is equal to the average of the open price and the low price that was set in the first hour of trading.
Do Gap Trading Strategies Work?
Many investors engage in momentum trading. To these investors “trading the gap” (also called “gapping”) is not logical. After all, what goes up must come down – and usually hard. So if a stock gaps up, it’s due for a correction?
This thinking can be true for stocks that show weak fundamentals, or when the market is trending down. In those cases, gap-up stocks – no matter how strong the lift – rarely stay at those levels. However, that thinking can work against investors when the right conditions are met.
For example, in a bullish market, a stock that is showing strong fundamentals may gap up after a strong earnings report. When institutional investors learn about the bullish report, they may drive the price even higher. If traders stay away from the stock believing that momentum is working against them, they may miss out on significant gains.
The Bottom Line on Gap-Up Stocks
One of the easiest ways to trade stocks, especially if you are looking to become a day trader is to look for gap-up stocks. Gap-up stocks are stocks that show significant price movement after the stock market closes for the day.
Investors can find gap-up stocks at any time. However, they are particularly common during earnings season when top line and/or EPS numbers that beat analysts’ expectations can cause a stock to surge. Today’s online stock screeners give investors an easy way for traders to identify and track gap-up stocks.
Trading gap-up stocks requires a disciplined system that requires traders to use trailing stops at well-defined entry and exit points to limit loss and protect profits. Not every gap stop is ideal for trading. Investors need to pay attention to other technical indicators such as trading volume to decide whether or not a stock may produce a profitable trade.