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 down" are companies that open at prices that are significantly lower than their previous closing prices, often due to after-hours news items that negatively affect investor perceptions of the company's value. More about gap down stocks.
Trading gap-down stocks can be a profitable strategy for active, risk-tolerant investors
Gap-down stocks are stocks that open at a lower level than the previous day’s closing price. A signature feature of a gap-down stock is a sharp downward price move with no other trading occurring before or after. This movement creates a price gap. Investors can identify gap-down stocks during after-hours and pre-market trading. Reasons why a stock may gap down include the release of news about the stock, such as an earnings report that missed analysts’ expectations or some sort of geo-political event that may incite speculators to bid down the price of the 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.
Why Are Gap-Down Stocks Important?
Anytime an investor identifies a stock that is gapping down, it indicates 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.
Investors who want to trade gap-down stocks can easily find them by using a stock screener. Once investors identify a potential gap-up stock to trade, they 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, the stock may show a significantly large gap. However, the trading volume for these stocks is typically fairly low. This not only explains the gap, but also is a good indication that it may be difficult to trade.
How Can Investors Interpret the Significance of a Stock that is Gapping Down?
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 occurs when a stock opens below 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 XYZ closes at $35. However, during the day the stock was trading as low as $32 per share. When the market opens on the following trading day, the stock was at $31. This indicates a full gap because the price was below the previous daily low. However, if the stock opens between $32 and $35 it would be a partial gap because the stock price would be 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 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.
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.
One 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.
What are Some Effective Trading Strategies for Gap-Down Stocks?
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.
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-down stocks. These will occur one hour after the market open (typically 10:30 A.M. EST). These strategies also work for after-hours or pre-market trading.
- 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-eight 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 short stop two ticks below the low achieved in the first hour of trading.
What Is a Dead Cat Bounce and How Can Investors Successfully Trade It?
A dead cat bounce is a short trading strategy unique to gap-down stocks. 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.
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.
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
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.
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.
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.