Summary - Trading with the trend is one of the keys to successful technical analysis. Stock traders have no shortage of daily charts and analytics to help them track price movements and determine key metrics like support and resistance levels when looking for stocks to buy or sell. One very visual technical indicator is the concept of gapping. When a stock shows a gap it means there has been significant price movement after the stock market has closed for the day. This after hours or pre-market activity can put the stock price at levels above or below the previous day’s high or low or above or below the previous closing price.
When this price movement is negative the stocks are said to be gapping down. These gap-down stocks can either show a full gap, marked by a price that is below the previous day’s low price or a partial gap, where the price is below the stock’s closing price. While gap-down stocks are easy to identify, successfully trading them can be a little more complicated. Part of the reason for that is because gaps happen for a variety of reasons. Some gaps have staying power, allowing the price trend to continue. On the other hand, some gaps are filled quickly. For this reason, gap trading is considered to have more risk and reward for investors. However, while once seen as exclusively the domain of institutional investors, today the prevalence of stock screeners and trading software allow individual investors, particularly day traders to have access to the after hour and pre-market data needed to successfully identify and trade gap-down stocks.
Effective gap trading strategies are executed in the first hour after the opening bell. This is because the first hour will typically allow investors to see if the trend is sustainable and also to track areas of support and resistance that are critical when setting trailing stops. Trading gap-down stocks in many cases requires taking a short position, which can leave an investor more exposed to risk.
On any given day on any of the major stock exchanges, it’s not uncommon for stocks to display volatile price moves within the course of a trading day. However, high-frequency traders, particularly day traders understand – and attempt to profit from – the activity that happens after the market closes. For example, during earnings season many companies release their earnings reports after hours. If the report comes in below analysts' expectations, it can cause the stock price to fall during after-hours or pre-market trading. When that happens, the savvy investor will notice a gap in the stock price before the opening bell. When the gap indicates a price that is below its prior closing price or below the previous day's low price, the stock is said to be a gap-down stock.
A gap-down stock indicates a trend that may either be short-lived (i.e. the gap fills quickly) or could be the beginning of a negative reversal for the stock. Trading the gap requires discipline and an understanding of how to analyze the gap. An effective trading strategy will also require the use of trailing stops that will help the trader exit the trade before key levels of support or resistance are breached (which usually indicates the trend is breaking).
In this article, we'll dissect gap-down stocks by defining what they are and how traders identify them. After that, we'll review the different kinds of gaps and how to identify them. We'll also review some of the more common trading strategies for gap-down stocks.
What are gap-down stocks?
Gap-down stocks are stocks that open at a lower level, often signified by a sharp price move, with no other trading occurring before or after, therefore creating a price gap. Gap-down stocks are typically identified during after hours and pre-market trading due to the release of news about the stock, such as an earnings report that missed analysts’ expectations or some sort of geopolitical event that may incite speculators to bid down the price of the stock.
Understanding full gaps and partial gaps
The gap in a gap-down stock is either a “full gap” or “partial gap”. A full gap occurs when a stock opens at a lower level than the previous session’s low. A partial gap is when a stock opens below the previous day’s closing price.
An example of a gap-down stock can be provided with Company X. During the trading day, the stock closed at $35. However, during the day it had gone as low as $32 per share. When the market opened on the following trading day, the stock was at $31. This indicates a full gap because the price was below the previous daily low. Had the stock been between $32 and $35 it would be a partial gap because the stock would be opening below the previous close but above the previous day's low. For many investors, full gaps offer a better trading opportunity because they provide a bigger window for profit (sometimes the gap can be in place for several days). This is, in part, due to what a full gap suggests about supply and demand. If a gap-down stock opens below the previous daily low it means the stock is under tremendous selling pressure. This increase in selling demand signals the market maker that the stock requires a significant price change to fill market orders. With a partial gap, the demand does not typically require a large change in price.
Why are gap-down stocks important?
Anytime an investor identifies a stock that is gapping down, it indicates that there is a large volume of sellers. However, what's harder to tell is whether the gapping action is short-lived or whether it will continue to become a trend.
The good news for investors who want to trade gap-down stocks is that they can be easily found by using a stock screener. In many cases, a stock chart can be specifically sorted to show only gap-down stocks. Once you identify a potential gap-up stock to trade, you should carefully study the longer term charts of the stock to check for clearly defined areas of support and resistance. 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-down 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.
One word of caution should come into play here. Although any stock can gap down, significant price movement can be common with penny stocks or other obscure stocks. In this case, you may see significantly large gaps. However, the trading volume for these stocks is typically fairly low. This not only explains the gap but also is a good indication that they may be difficult to trade.
Understanding what a gap may signify
As we mentioned above, identifying a gap-down stock is easy, but understanding what the gap is signifying is a different challenge, but crucial to the success of a trade. Beyond the terms full gap and partial gap, gaps generally fall into one of four categories:
Breakaway Gap– This is a gap that takes place at the end of a pricing pattern and signals the start of a new trend. A breakaway gap coincides with high volume.
Exhaustion Gap– This is a gap that takes place near the end of a pricing pattern and represents a final attempt to set a new high or low. An exhaustion gaps coincides with low volume.
Common Gap – A common gap is one that cannot be placed in a price pattern. It simply represents an area where the price has gapped.
Continuation Gap– This is a gap that occurs in the middle of a price pattern and signals 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. A psychological reason for this is that it’s not uncommon for analysts to be overly pessimistic and push a stock down too much. In this case, there will almost always be a correction as the market absorbs the news and investors push the stock higher. If the movement is done without firm support and resistance levels, the stock may revert back because there is nothing to keep it anchored at that level. Also, exhaustion gaps are more likely to be filled since they happen at the end of a pricing pattern. In the case of a gap-down stock, the end of a pricing pattern is a signal for buyers to start entering the stock, making it more likely to start an uptrend.
How to use common gap trading strategies
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).
Full Gap Long Position (Buy): Set a long trailing stop at two ticks (defined by the bid/ask spread) above whatever the previous day’s low stock price. The bid/ask spread is usually either one-eighth or one-quarter point.
Full Gap Short Position (Sell): Set a short trailing stop at two ticks below the lowest stock price reached in the first hour of trading.
Partial Gap Long Position (Buy): Set a long stop two ticks above the high achieved in the first hour of trading.
Partial Gap Short Position (Sell): Set a shortstop two ticks below the low achieved in the first hour of trading.
These strategies work for after-hours or pre-market trading as well.
What is a dead cat bounce?
A dead cat bounce is a short trading strategy unique to gap-down stocks. The general idea behind a dead cat bounce is a stock that gaps down in overnight trading, continues to go down at the opening bell but then rallies to a point near the opening price before continuing its downward trend. A dead cat bounce is a significant psychological market event that is triggered by a significant market event that causes a wave of selling. Even though the stock may move up a little bit, it is really just an opportunity for sellers to get out.
For a dead cat bounce to exist a few conditions need to be met.
- The stock must show a significant gap from the prior day’s closing price. If the stock is not considered to be volatile, many traders use 5% as a guideline. For volatile stocks, they usually look for a much larger gap.
- The stock must decline for at least five minutes once trading begins. If the price doesn’t keep falling, there can’t be a bounce.
- The stock will then start to rally in an area close to its opening price. This will typically represent a resistance level. This is where traders should be looking to take a short position.
- The stock will then fall again. This is the confirmation that the stock is indeed having a dead cat bounce.
The bottom line on gap-down stocks
Gap-down stocks are stocks that show significant downward price movement in after hours or pre-market trading. Although stocks can gap down at any time, they are common during earnings season when a report that falls short of analysts’ expectations can trigger a wave of selling. Stock screening tools make it easy for investors to find gap-down stocks, but identifying which ones make good trading opportunities requires a bit more sophistication.
Gap prices can either reflect a full gap or a partial gap. And fit in one of four categories: A breakaway gap, an exhaustion gap, a common gap or a continuation gap. Knowing what type of gap is the key to successful trading.
Gap trading strategies require a disciplined system that includes the use of 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 gap-down stock may produce a profitable trade.