Gap Trading By: David S. Nassar With the increasingly volatile markets recently, many issues indicate supply/demand imbalances at the open. open. These imbalances imbalances present present themselves as what are known as “gaps”. “gaps”. Listed stock gaps are created by order imbalances before the open, and OTC gaps occur when market participants of the Nasdaq indicate interest for stocks in terms of opening price quotes. News is generally the catalyst that fuels these imbalances, and news comes in a variety of forms, such as macro economic news (FOMC meeting, for example), fruition of events from the economic calendar, or stock-specific news, like earnings announcements, ratings changes, etc. Regarding market reaction to news, when buying interest exceeds selling interest, the gaps are obviously going to be to the upside, and visa versa. What is not as obvious is the level at which a stock will open, as well as the risks associated with gap exposure. A few years back, these level s were often deter mined by large “off floor” mark ets, the t he most mos t prominent being Instinet. Instinet was the first pre-market tradin g medium, and was a purely institutional tool, hence its name. Today, with public acceptance of many other active electronic communication network s (ECN’s), pre and post mark et trading has a much greater number of participants, due to the representational influx of the public interests. In reality, although the public has access to this market, pre-market price levels are still most heavily influenced by market makers’ stock bids or offers put forth at price levels above or below the previous day’s closing prices (when price imbalances appear in their automated 24-hour trading systems). Because many of these are “market on open” orders, market makers have an incentive to open a stock at extreme levels directly correlated to the imbalance. Simply stated, this means that if an imbalance falls onto the demand side, and a given issue is going to open with strength, market makers are incented to open the stock as high as possible, while filling the market orders at the open. This gives the market maker the legal opportunity to sell stock from their inventories, or short stock to buyers who are willing to buy “at the market”, which means that they have no price protection, as they would by specifying a limit price (using a limit order). It has been said that, in bull markets, “yesterday’s highs are today’s lows”, but often, in the case of gap openings, the opening prints mark the highs of the day. Because most members of the public trade only the bullish long side of the market, many unsuspecting amateur traders trade into gap openings, into these very high points. It’s important to explore situations when a gap will not hold and close, or when they do hold and follow through. This is perhaps the strongest indication of the immediate post-opening trend for these gapping stocks. In the example of bullish gaps, stocks that fail to meet the levels of the gap opening have a greater propensity to retrace and close much of the opening gap, as opposed to the closing print from the prior day’s trading. Conversely, stocks that remain strong and trade to new highs after the open will have a greater propensity to follow through and trend higher. While this is not to be interpreted too literally, and there are other indicators to monitor (such as indicie strength, sector strength, etc.), it is the strongest single indication of how a stock will trade following a gap opening. In the example of bearish gaps, as a rule, the opposite is also true . Stocks that hold a price level after gapping down will often close the gap and trade higher, while stocks that find new lows after a gap tend to follow through and trend lower. In either case (bullish or bearish gaps), it is important to study the impact that gaps have on stocks after the open. The components and considerations I have found to be most important when gap trading are: • •
Charged Stocks/Sectors Volume and Volatility
• •
Chaotic and Overactive High Risk (Elasticity)
Charged Stocks/Sectors
A stock or sector becomes “charged” due to volatility. Once a sector is in the public eye, I think of the component stocks as being “charged”, and will, therefore, trade with wider price ranges. When this occurs, obviously the stock’s volume stock will be heightened and there will be a tremendous price range from trading session to trading session (either to the upside or downside). In the absence of actual trade activity, Nasdaq Market Makers will predict price pattern changes slightly before or immediat ely after an event occurs. They will bid stock higher or lower based on their predictions of the imbalance that will occur, and price these issues accordingly. Once a major stock within a sector experiences negative or positive news, it can “charge” an entire sector. The chart in figure 1.1 shows INTC gapping down after negative news on inventories. This news (and its effect on Intel) caused the entire Philadelphia semi -conductor index (SOX) to became charged and volatile immediately after. As you can see from the chart, INTC did not hold its levels after the first gap, and followed through by trending lower. The first clues that a stock is a potential candidate for gapping is an increase in volume over its normal daily average. Often the increase in volume will be seen before the news is known. This is an indication that news is leaking into the market, and illustrates the cliché, “stocks tell there own stories” ahead of news. Remember, the biggest trading houses often have strong indications of sector and stock strength/weakness before the media, therefore, when increases in daily volume accompanied by directional bias are seen in the absence of news, a gap is generally not far behind.
Figure 1.1
Volume and Volatility I choose to track vo lume by knowing the average daily volume traded by a stock or sector, and more importantly, where the issue’s key price levels are. Volume is the best indication I have ever used when sectors or stocks move closer to key levels (support or resistance). As a day trader, watching the ticker or tape is an excellent method of monitoring changing volume for short-term intra day trades. If the ticker is moving rapidly, you are seeing an increase in volume. It is that simple. Such conditions typically signal the setup of a “Vertical Spread” (VS) Situation. A high VS indicates a rapidly changing price pattern. A trader should seek to lead the market; to buy or sell as ranges widen. A slower moving issue with a tight “Horizontal Spread” (HS), where the spread between the bid and ask is tight, (less than 5 cents) will n ot require leading. In a low HS spread stock, a trader can easily “lift offers” or “hit bids” or even buy bids and sell offers during tight price range situations. As volume increases in the short term, the less rapid prices change, but the greater chance of sustained price change over time, hence representing a trend formation pattern over a series of days. In order to spot volume indications that my lead to gaps, a macro view of volume and the market itself is more useful. Again, refer to figure 1.1, and notice the dramatic increase in the stock’s volume over the course of days. But within intra-day moves, this condition of volume will change, and, once the stock starts to move, it will have the greatest movement on the leas t volume. For example, when stocks are growing weaker, panic and fear are heightened, and, as a result, fewer buyers are coming forward. Therefore, as buyers dissipate in the market, stocks fall harder (with a wider range) before new support levels are found. Once support levels are found, the volume builds dramatically as the number of buyers remains strong at support levels, buying huge volumes while sellers are still in the market. It is at these levels that the true battle between bulls and bears takes place. The battles are illustrated through heavy buying and selling, indicating stalemated small price movement, unresolved until one side gains control over the other. Whether bullish or bearish, once a clear imbalance is revealed, volume tends to dry up as market participants amas s on one side of the supply or demand equation. For example, if the bulls gain control at a key support level, buyers will exceed sellers and, in the absence of sellers, stock will trade higher on less volume, as buyers lift thin offers at each price level. The lesson to be learned is that volume indicates where the battles are fought between bulls and bears, but once a dominate bias is reveled, the stock will move t he most on light er volume, compared to the volume where battles are fought at suppo rt and resistance levels. Gaps are the ultima te exampl e of this (where no volu me exists, but extreme price change does). Once this gapping action begins, chaos is not far behind. Chaotic and Over reactive
Chaos is at its climax when stocks have no established support or resistance levels. For example, if an issue is not well supported until a stock trades 20 points lower, then volatility will be extreme. When these conditions exist, it is strictly a “day trading only” environment, where taking overnight positions is an unwise risk. Tighter risk tolerance rules this climate. Day trading methodology is much more risk averse and profitable if followed with discipline. Remember, volatility can also be defined as chaos, and, therefore you can throw your technical tools and indicators out the window. A trader who wants to trade in this climate must take a micro view of the stock, taking small incremental profits and losses versus trying to trade the overall trend. Please note that gaps can often reveal the beginning of such a trend, but because of the chaos associated with wild volatility within the trend, position trading is subject to too much “whipsaw risk” (see High Risk below). The position trader in these climates can count on nothing being small, not profits or loses. When a large relative range of movement occurs in a stock through increased volume and volatility, the chances of gap opening increase significantly with risk. For example, you may notice that Ciena (CIEN) has moved in a price range from 85 (support) to 115 (resistance) for the last 5 days. This means that the stock may move from one level to another over a period of time and then reverse the move, only to repeat it again. Or the stock trades down to a certain price level, finding support, and beginning to consistently move upward, which reveals the beginning of an upward trend. These patterns are so chaotic that position trading under such conditions is more associated with gambling. See figure 1.2
Figure 1.2 High Risk
A trader in these situations must have a much greater risk tolerance going into the trade and should understand that these price fluctuations are part of the equation. Otherwise, the trader who does not recognize this volatile range as being normal will constantly employ “discipline” at the wrong time and be “whipsawed” out of trades, taking many loses. If you’re going to trade these types of stocks, you need to employ greater risk tolerance and certainly you need clarity of the bigger picture or the broader price patterns, before considering adding these big-range stocks to your interest list. It is also important to dramatically lower your size in these trades, since the range in price offsets the trade size needed for profit. In short, it is like a hurricane, when you’re in it’s midst, it is only chaos and you can’t determine from where the wind is blowing, but if you can step away far enough (broader view) you can see the overall direction. Trade these issues accordingly, or just decide to stay away altogether! These characteristics are precursors to the “Gap Trade”, since these issues have the greatest propensity to gap open. If an overnight position is entertained, certain questions must be addressed first. To Trade or Not to Trade, That is the Question! Do you have the account size to absorb the potential gap? Do you have the temperament or risk tolerance? Are you “In the Money”, and wish to accept additional risk for additional reward? Is it really worth it? Do you have clarity and confidence that you see the Gap coming? Did you day trade this stock the entire day prior to the anticipated Gap? If you answered “No” to any of these questions, don’t even think about it! If you answered “Yes” to ALL of these questions…
Consider that with volatile price pattern movements during the day, stocks will tend to overreact or overtrade, while pushing prices artificially higher or lower during the day. This sets up the correction for the next trading session where market makers will often gap the stocks price to what they feel is equilibrium, or where they want to trade the stock for the open the next day. Remember, the first gap that sets the stock in motion is due to unforeseeable news and, as a rule, is not predictable. The gaps that may occur after the trading day following the original gap may arise for some of the following reasons. • • • •
Short Squeezes (Hook Closes) Profit taking (Hook Closes) Additional News such as Earnings releases S&P Futures Volatility
Short Squeezes
Short squeezes and Profit Taking are the most common reasons stock volume will tend to build to above-average levels into the close, causing what is called a “Hook” close. The short squeeze is simply a term explaining when a stock is on a downtrend for the day and Market Makers suspect there may be short sellers in the market as a whole. The squeeze occurs and so does the “Hook” when the professionals begin to buy the stock rapidly into the close, causing the prices to rise swiftly, causing the short sellers to cover in panic. See figure 1.3
Figure 1.3 Profit-Taking
Profit-taking generally occurs when a stock is in a rising trend for the day, and the stock shows a weak close, accompanied by high volume as “Long” traders begin to sell the stock to take a profit. See figure 1.4
Figure 1.4 A Note on Profits and Gap Trading…If I am not in a profitable situation from day trading the stock, I will not enter the overnight Gap trade. It is best to stand aside, and trade the open the following day if , and after, the issue gaps open. If, after profitably day trading the issue, you are contemplating taking the overnight position, then that is a risk/reward question only you can answer. Never hold a negative position overnight hoping the stock will “come back”. Such a tactic isn’t trading; it’s gambling. Only pursue an overnight position with purpose and confidence. Never turn a day trade into an overnight position because things didn’t go your way. Earnings
Earnings are perhaps the most significant factor impacting gap trades, since earnings have such a significant influence on stocks and sectors. The message regarding earnings is simple. The market punishes missed earnings to a much greater degree than it rewards earnings that meet estimates. Many companies meet expectations and still get hammered the day after earnings are reported because most positive earnings are built into the stocks price over the days prior to the report, unless there is a true surprise. For this reason, stocks have a greater propensity to fall when companies only meet expectations. When expectations are missed, the downside bias is dramatic. Therefore, I rarely take an overnight position involving a company that is reporting earnings after the close. If I do, my natural bias is to be short, especially in this volatile market environment. Because so many stocks see upside bias the days prior to an earnings report, I prefer to take a long position during this period, sell into the news and wait for the outcome. See figure 1.5 for an example of what companies experience when expectations are missed.
Figure 1.5 S&P Futures
S&P Futures are important to consider when taking an overnight gap trade. I like to look at the futures into the day’s close to spot a correlation relative to the position I plan to take for the overnight gap trade. For example, if the futures are exhibiting strength into the close, and all other factors and questions are right, I will go long into the close. If the futures are weak into the close, and I suspect a short play opportunity, I will consider this in my favor as well. A trader must have clarity when taking an overnight position for a gap trade. But perhaps the most significant piece information a trader can consider is the feel one gains by day trading the stock during the day. By day trading the stock the entire day, tick for tick, trade for trade, you can’t help but build the needed intuition to form the decision as to weather or not to engage in the overnight gap trade. A final word… Remember, gap trading is risky business, and the professionals who mark stocks up or down prior to the open have a vested interest in doing so. If you were a market maker who made your living buying and selling stocks from the public, while providing liquidity to the market, where would you open a stock with poor news, knowing you would be receiving “market on open” orders? You would open them as low as possible, (where you felt the stock was well supported). This is known as “buying weakness”. Conversely, with strong news on an issue, knowing you would be selling at the open, where would you open the stock? As a market maker, you’d open that stock at as high a level as possible (to enable you to short stock to buyers at would-be resistance levels). This is referred to as “selling strength”. This is why gaps have a greater propensity to close immediately after the open. If they continue to follow-through in the direction of the gap, then the indication is strong the trend will continue and the gap will widen. These rules should serve as a guide, but shouldn’t be traded with absolute literal indiscretion. Only monitoring and confirming indicators will form an overall bias.
Remember, trading is not gambling. Successful traders use a combination of intuition, technology, and decision-support tools such as the tape, Level II screen, price levels and charts to make an informed decision. The statistical advantage is gained by following your discipline while employing some of these techniques.
