In the first article of this series, we looked at the difference between gap continuations and gap reversals. In this article we’ll look at how to trade “minor” gap continuations, which are a favorite intraday trading strategy for stock and ETF day traders.
Minor Gap Continuations: Day Trading Strategies
Compared with multiple-point regular gaps, in which a stock or ETF gaps at least a point or more outside of the prior day’s close, “minor” gaps are gaps of less than 1 point in size. They are among the very best intraday trading patterns, because they have not gapped up (or down) so many points that traders are cautious about entering them.
If a stock gaps up 7 points on good earnings release news, for example, few traders will want to buy it, since it has already been priced up very high. On the other hand, minor gaps are often the start of a volatile price move that may well continue. Astute day traders are often on the lookout for these minor gaps, because they can potentially provide excellent trading opportunities.
A good example of a “minor” gap can be observed in Figure 1 [Ameriprise Financial, Inc. (AMP)], in which the stock’s price gapped up just a dime (.10 cents) on high volume, the morning that it then continued to move up a full point. Any of these small gaps, between .10 and 1.0 (ten cents to a dollar) can be considered a “minor gap” which should be traded in-trend on a gap continuation breakout, as they reach new highs above the prior day’s high (for longs).
Trading Minor Gaps: The Fine Points
When scanning for charts with minor gaps in them, there are a handful of considerations to take into account when deciding which charts provide the best potential trade setups:
Tip #1: The gap must occur above the prior day’s high, for a long continuation, or below the prior day’s low, for a short continuation. Something that gaps inside the prior day’s high-low range does not qualify.
Tip #2: The best setups are those in which a minor gap follows a prior-day’s chart that closes at or near the day’s high (as can be seen in Figure 1).
Tip #3: Trading minor gaps is a matter of setting entry triggers just above prior highs (for example, with small bullish cup pattern breakouts, for longs).
Tip #4: Adding to winning gap continuation plays, for scaling in to winning trades, should be done before the price has extended beyond 2/3 or so of it’s Average True Range (ATR).
Tip #5: It’s often useful to use a 5-minute candlestick chart to check for the presence of a contrary indicator (such as a gravestone doji, shooting star, or bearish upper shadow), prior to entering, to stay away from the trade if a signal like this is observed.
Minor Gap Trades: The Start of Breakout Continuations
The reason minor gaps occur premarket is because of the buy/sell order imbalance from premarket order flow, which is managed by a specialist, market maker, or automated system. Spotting these minor gaps provides breakout traders with a “foothold”, or starting place, from which to build a breakout trading position.
When trading breakouts, it’s often a good idea to trade larger size in these minor gap continuation trades, scaling in to them as they continue moving up. These are the author’s favorite day trading setups, because minor gaps illustrate the “sweet spot” between a breakout that’s likely to continue, versus an overbought multiple-point gap up that may consolidate or trade back down into it’s trading range.
It’s a good idea to scan for these initial minor gaps using premarket charts before each day’s opening bell, to be prepared for potentially trading them, if they start to get new buyers on breakout gap continuation price action.
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.