Gap Play

There is a popular saying in trading, “Amateurs open the market, but professionals close it.” That saying refers to the massive amounts of orders that brokerages have to fill at the open as a result of amateur traders and investors flooding them with buys and sells from news they heard in the afternoon or evening. Typically the professionals and institutions will wait for the day’s trend to develop before working out their purchase or sales price in the afternoon. However, fueled by fear and/or greed, the novice jumps in as soon as they can when the market opens or even in the pre-open.

When there is an influx of orders, the brokers will want to fill them as soon as they can since they earn their commission from the order flow. But this rush to fill the orders can exhaust the momentum and cause additional swings in the morning. As an example, let’s suppose the market looks bullish. You hear good news about a company and want to buy their stock. You must remember that you are not the only person who has heard this news nor are you the only person submitting a buy order.

In the pre-open, the exchanges look at all of the buy orders and sell orders being received and try to match them at an opening price that would best fill the greatest number of orders for the customers. This is great except, if the majority of buy orders have been satisfied in the pre-open, then how will the price rise when the markets open? Think about it. If everyone who wanted to buy just got into their stock, then there will not be the demand needed to push prices higher at the open.

Often, the large demand for stock will cause the price to gap up on the open into a level where many sellers are waiting. This area is called resistance. It is an area where prices had collapsed in the past due to an imbalance of buyers and sellers. If the demand is exhausted in this area, could the price go anywhere but down? This offers a great opportunity for an intraday trader who can identify the levels properly.

Gaps are a normal part of trading. Traders can view these gaps as a great inconvenience or an excellent opportunity. The key is to see what the price action is telling you after it gaps. An interesting thing to see is whether prices were able to gap beyond the prior day’s price action. When I speak of the prior day’s price action, I am referring to the movement of price between the prior day’s high price and the prior day’s low price. If prices gap but do not open above the prior high or below the prior low, then the gap is called an inside gap and is likely to fill during that day.

As an intraday trader, I can identify stocks that are exhibiting this pattern and plan trades to take advantage of the gap filling as long as the Nifty is also confirming the movement. This could also have huge implications for swing traders as a gap that occurs opposite to their position may be able to be ignored thus preventing panic and an early exit.

Should price gap above the prior high or below the prior low, then the gap is considered to be an outside gap. Outside gaps also offer interesting trading opportunities. They tend not to fill in the day but will change direction at the prior high or prior low. If a stock does gap above the prior day’s high, it is an outside gap and will likely only fill until it reaches the prior high which will act as support. If the markets are bullish, then expect a bounce here for a long.

If the stock gaps down and tries to fill the gap, often the prior low will act as resistance and cause the stock to drop from that point thus identifying a shorting opportunity.

There are always exceptions to these guidelines on gaps and traders should exercise caution and discretion when identifying trading opportunities surrounding gaps. Look at the broad market and also larger trends for guidance and above all, place protective stops to manage your trades. Trade safe and trade well!

Learn to Trade Now