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How to trade gapsEven though we briefly alluded to gaps, how to trade gaps is a subject that warrants more time, considering the impact they can have on your portfolio, good and bad… First of all, what are gaps? There are essentially three ways the price of a stock can open: It can open higher, lower or at the same price. If the price is at least 3% higher we call it a gap up and if it’s at least 3% lower, it’s a gap down… What causes gaps? Late breaking news in specific stocks, earnings report, analyst upgrades or downgrades, overnight futures trading, economic news, major world events, or simply an imbalance between supply and demand causes gaps. Regardless of the specific catalyst, gaps occur due to excess demand on the buy or sell side, which is further exaggerated by low volume trading that take place outside of the regular market hours. Emotions play a role as well. Large gaps often result from traders overreacting to news in after-hours trading. Not wanting to miss out on a big move, people get excited and buy or sell impulsively causing the prices to move even more dramatically. The reality though is that once the market opens and liquidity returns to normal, the exaggerated prices tend to correct themselves with a snapback price reversal. But not all the time as I will explain in more details later. Understanding this concept will give you an edge that will allow you take advantage of this predictable phenomenon. Although the size of gaps varies, they occur almost everyday. On a given day, gaps are generally traded during the first 30 minutes of the day. The short time frame for trading gaps is why they provide such a great part-time trading opportunity. The length of a gap trade can range from seconds to minutes, to hours, or occasionally, all day if a gap reversal gains momentum in the opposite direction and you decide to trail the move for as long as possible. On a weekly basis, I believe the best days for gaps tend to be Monday’s and Friday’s, though any day of the week could turn out to be a good day. Increased uncertainty is one of the reasons. Going into a new week, no one knows for certain how the market will behave, either that day or for the rest of the week. Similarly, the uncertainty going into the weekend is a factor on Fridays, though less so than on Mondays. The increased uncertainty often causes more volatility, which results in larger gaps. How to trade gaps?
By the way in intra day most gaps will reverse. So here I am discussing the effects of gaps on a daily chart: There are three types of GAPS:
-This is the most common gaps -Occurs both in trending and consolidating stocks. -80% of them will close within 5 days. -The issue here is to differentiate it with the breaking gaps, we will see further who’s much more interesting. Significant gaps There are three types of significant gaps:
-Transforms a consolidation period into trending -The longer the consolidation the longer the trend will last -High volume the day of the gap (+/- twice the average volume) -If TA (technical analysis) agrees, take a position quickly. -Best to swing trade Vs. day trade since the trend will likely last for days. Here’s an example of a breaking gap:
Now, on with the Trending gaps: - Happen while trending and actually maintains the trend - The target price can be estimated with it and is usually equal to the distance between the start of the trend and the gap ( when you get closer to the target price you might want to tighten your trailing stop) - Volume should be +/- 50% higher then the days before the gap. - Make sure the stocks makes higher highs ( or lower lows) many days in a row because if it doesn’t it might become an exhaustion gap. - You might want to wait one day to make sure of the gap’s personality before jumping on this one. If you do it quickly, make sure you can follow it or have a tight stop Here’s an example:
And finally here's the exhaustion gap: - Occurs while trending but can also precede or follow reversal of tendency. - Is NOT followed by higher highs or lower lows many days in a row - Again volumes should be +/-50 higher thean the days before the gap. - Can look like a trending gap if it happens right after a reversal Here’s an example:
Here’s a look at the three gaps on the same chart to help bring it together to help you understand how to trade gaps:
And finally, the most famous of all: The dead cat bounce -Usually gaps overnight by at least 18%. If it happens during the day it will be following a halt. -Caused by a major news like a profit warning, Class action, suspicious accounting practices, missing estimates, terrorist attacks… After the initial fall, the stock will rebound with: *The amateurs sensing a “deal” or averaging down. *The investor will hold on to it until death do them part… *The day trader will take advantage of the bullish momentum and *The institution will institute some program trading and averaging down, while the market makers/specialist will short the stock Once everybody think they’re out of the woods, the dead cat who just bounced, is still dead so it starts falling again: *Institutions liquidate their position while telling the investors the company is going to be alright… *The day trader goes with the flow and short the stock so do the MM’s. *After a few of these bounces the amateur finally decides to liquidate his position, while the investors still hold on… and so it goes on… If you want to see a famous dead cat bounce look at Nortel charts when it started coming down from its hig... Traders who caught on to this dead cat bounce made a fortune! Like I said earlier how to trade gaps is a very important chapter and you need to take the time to assimilate this information because this alone could mean the difference between being an average trader vs. being a very successful trader/investor... Now let's move on from this chapter dealing with "how to trade gaps" to the next chapter which I believe deals with a subject that separates trading from investing: SHORTING STOCKS 
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