(StockCharts.com)
Gap trading is a simple and disciplined approach to buying and shorting stocks. Essentially one finds stocks that have a price gap from the previous close and watches the first hour of trading to identify the trading range. Rising above that range signals a buy, and falling below it signals a short.
What is a Gap?
A gap is a change in price levels between the close and open of two consecutive days. Although most technical analysis manuals define the four types of gap patterns as Common, Breakaway, Continuation and Exhaustion, those labels are applied after the chart pattern is established. That is, the difference between any one type of gap from another is only distinguishable after the stock continues up or down in some fashion. Although those classifications are useful for a longer-term understanding of how a particular stock or sector reacts, they offer little guidance for trading.
For trading purposes, we define four basic types of gaps as follows:
A Full Gap Up occurs when the opening price is greater than yesterday's high price.
In the chart below for Cisco (CSCO), the open price for June 2, indicated by the small tick mark to the left of the second bar in June (green arrow), is higher than the previous day's close, shown by the right-side tick mark on the June 1 bar.
A Full Gap Down occurs when the opening price is less than yesterday's low. The chart for Amazon (AMZN) below shows both a full gap up on August 18 (green arrow) and a full gap down the next day (red arrow).
A Partial Gap Up occurs when today's opening price is higher than yesterday's close, but not higher than yesterday's high.
The next chart for Earthlink (ELNK) depicts the partial gap up on June 1 (red arrow), and the full gap up on June 2 (green arrow).
A Partial Gap Down occurs when the opening price is below yesterday's close, but not below yesterday's low.
The red arrow on the chart for Offshore Logistics (OLG), below, shows where the stock opened below the previous close, but not below the previous low.
Why Use Trading Rules?
In order to successfully trade gapping stocks, one should use a disciplined set of entry and exit rules to signal trades and minimize risk. Additionally, gap trading strategies can be applied to weekly, end-of-day, or intraday gaps. It is important for longer-term investors to understand the mechanics of gaps, as the 'short' signals can be used as the exit signal to sell holdings.
