Trading gaps for swing and intraday trades is a favorite strategy used by active traders. Also known as “windows”, these powerful moves often occur following major news or earnings-related news, and can provide excellent trading opportunities. This is because the price action is often institutionally-driven, showing extraordinarily high volume and volatility.
Trading Gap Continuations: How It Works
A gap continuation occurs when a stock (or ETF) price continues in the direction of the gap. For example in Figure 1 [Fresh Market, Inc. (TFM)], the stock price gapped from 49 on May 29th up to 52 on May 30th, a 3 point gap. It then continued up to close over 56, a 4-point intraday long move, on high volume.
These gap continuations trades are a favorite trading strategy for active traders, because of the high volume and volatility, plus price action that takes them to new highs. It is often erroneously assumed, by book authors and novice traders alike, that gaps reverse more often than not. This however is usually not the case. Most gaps continue in-trend, and traders should be on the lookout for these premarket and multi-day gap trading opportunities.
Tip: check a 15-day chart of the S&P, Dow Jones or NASDAQ and see how often days continue in-trend following gaps, versus “fade” or reverse back into prior trading ranges. You will often find that gaps continue, using the broad market indices as a good overall barometer of gap trading behavior. Note that during strong up or down-trends, this tendency for markets, sectors and equities to continue in-trend is even more pronounced.
As with most stock and ETF entries, it is often to simply look for in-trend continuation entries by using a buy-stop limit order that’s .35 to .50 (thirty-five to fifty cents) above the opening price following a gap, to trade an in-trend directional gap move. Check for yourself the percentage of time that stocks and ETFs continue vs “fill” or pivot following gaps, to confirm that for the majority of gaps, for instruments priced $20-$70/share, gaps do in fact continue the majority of the time.
Trading Gap Reversals: When Gaps Fill
Many trading books and courses mistakenly cherry-pick “gap fill” examples and give bad advice like “buy gaps down” or “sell gaps up”, when in fact gaps continue in-trend more often than not. Looking at recent longer-term 90-day charts of stocks like Netflix (NFLX), Green Mountain Coffee (GMCR), and even recent IPO charts like Facebook (FB) and others, one can find many examples of gap continuations.
However, there will be a small percentage of times where gaps will reverse, or “fill”, and astute traders can also be on the lookout for these. Those who, like the author, are breakout traders, do not like to trade gap fills or pivots, since trying to “outguess the market’s directional moves” is usually a losing proposition. Gaps are there due to institutional premarket trading orders on high volume, so it’s wise to follow institutional money flow, by trading in-trend for most gaps, once they take out continuation support/resistance levels.
One example of a rare gap reversal can be found in Figure 2 [Vertex Pharmaceuticals, Inc. (VRTX)], in which a gap down to 50 got buying over a two-day timeframe to “fill” the gap, back up to near 61. To trade these types of gap reversals, looking for signals like “cup” patterns, (or candestick hammers, on daily charts), can provide trading entry signals worth considering. Resistance levels are usually found by simply looking at prior day’s trading ranges (for example, 60.0 is resistance, from the support on May 18th in this chart), which would be the maximum profit target for a gap reversal trade.
Gap Trading Plan: Taking Action
Developing a scanning and trade management plan that incorporates gap trading is a useful addition to active traders’ trading activities. Daily leaderboard (percent gain/loss) lists often help locate these gap plays as they occur, and following up with disciplined, carefully managed entries, targets and protective stop losses can help traders design a plan that makes sense for capitalizing on gap trading opportunities.
Ken Calhoun is a trading professional who has traded millions of dollars of equities since the 1990s, and is the producer of multiple award-winning trading courses and video-based training systems for active traders. He is a UCLA alumnus and is the founder of DaytradingUniversity.com, a popular online educational site for active traders.