Featured Article

Measuring the Gap Fill

BrandonWendell
Brandon Wendell
Instructor, CMT

There are a lot of gaps on stocks listed in the Indian markets.  This is partially due to the nature of how the opening prices are determined for the exchanges.  Knowledge of how to trade the gaps can be extremely beneficial for traders willing to take on certain risks to increase their potential profit.

The gaps are formed from excessive supply or demand that is present just before the open.  The exchanges collect orders in what is called the pre-open auction from 9:00am to 9:07 am and then try to match these orders at one price that will allow for the most orders being filled.  If there are a lot of buy orders but few sellers, the price will obviously gap up to satisfy the demand.  Should there be an abundance of selling orders versus buyers  in the pre-open, prices will need to be pushed down and gap down to fill those orders.

It is important to note that none of the orders are actually filled until the official opening at 9:15am.  But when that first trade occurs, it is often not at the same price at which the markets closed the prior session.

In prior articles, I discussed the types of gaps and what to expect when attempting to trade them.  In the event that the gap does not fill my trading in the price levels of the gap during the actual trading hours, I wanted to discuss a tool that can be useful for traders wondering where to exit profitable trades.

Fibonacci retracements are a tool that we discuss in class.  This tool is very versatile and can be used to measure the probable retracement of a price move.  You need to understand the difference between an impulse and a correction (retracement), to fully understand how to use them properly.  I won’t go into that detail here because it is reserved for those who attend our Professional Trader Course.

As I mentioned earlier, you can also use the Fibonacci retracement tools in order to measure how much of a gap has been filled or where the gap filling action may stall.  There are two different methods for applying the Fibonacci retracement tools to gaps, the traditional method and the modified method.  I prefer the modified for my trading.

The traditional method involves placing the start and finish of the Fibonacci retracement lines at the prior close and the current opening prices.  This measures the size of the gap itself and assumes that if prices stall while trying to fill the gap, they are likely to only fill a portion of the gap itself.

bwendell 20120327 gap - traditional-fib-up

bwendell 20120327 gap - traditional-fib-down

The second method, which I typically use, is to assume that the gap is part of the price movement.  I will start my Fibonacci tools at the bottom of the price movement that occurred prior to a gap up and finish it at the high where prices started to turn down and fill the gap.

Figure 2: Modified Fibonacci on gap up

If there is a gap down, I will start the retracement tool at the high preceding the gap and end it at the point where prices turn higher and try to move into the gap itself.

Figure 2: Modified Fibonacci on gap down

If the gap attempts to fill immediately then the retracement would still start at the beginning of the move prior to the gap but terminate at the opening price of the current day.

In using these Fibonacci levels, I watch for weakness in price as it approaches the levels.  Should price stall at one of the levels, it may be a signal to exit from my gap filling trade at that point.  Whichever method you use, it is important to establish rules and be consistent in your trading.

To learn more about how to use Fibonacci and trading the gaps properly, come take one of our courses at Online Trading Academy.  Your trading knowledge gained in the class will become your greatest financial asset.

Disclaimer
This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.