Mind the Gap...in the Market

Originally published on Equities.com., November 8, 2016.

I was teaching a class in our Campus in the U.K. this week and when getting on the train I saw the sign “mind the gap” on the ground before boarding. This sign has almost become a novelty, showing up in souvenir shops and on t-shirts, but why does it exist? This sign is there to act as a warning and keep passengers safe from the dangers of the dreaded gap. When I speak to new students and new traders, this is how they treat gaps in the market and have tended to avoid them. What if there was a way to benefit from the gap that others perceive as risky?

The first thing we have to do is to define a gap. A gap is simply the difference in price from one period's close to the next period's open. This most often occurs when a market is closed, although it is certainly possible to occur during the day when the markets are open. A gap up is when price of one period opens higher than the previous period's close. A gap down is when price of one period opens lower than the previous period's close.

How to trade the gap.

These gaps are potentially dangerous to investors, especially to those that do not know how to trade them. The biggest fear about gaps for active traders is the fear that a stop loss will not be activated at their desired price. Look at the picture below of LinkedIn.

What is a gap up?

If a trader owned LinkedIn (LNKD) at $200 per share and they put a stop loss at $190 per share then on the gap down on 02/05 would have gotten them out a roughly 125.34 per share. That kind of event is the kind of thing that people afraid of gaps will use as cautionary tales that will keep them out of the markets and missing out of potentially advantageous trades. Do these occur gaps occur in a vacuum? Typically a gap happens around news or earnings, and so a cautionary tale to traders is to not hold equities over news releases if they are looking for short term gains. But to really take advantage of gaps, let’s look at two ways to play gaps. The “Gap and Go” and “Fading the Gap”. Both of these strategies are dependent on the only thing that truly matters in the markets, real supply and real demand.

Price moves to areas looking to establish a balance between supply and demand. The origin of any move in price is the area where either buyers or sellers become zero at a specific point, and the orders left behind from that move will become “magnets” for price in the future. If price gaps into one of these areas, for example price down into an area of unfilled buy orders (an Online Trading Academy Demand Zone) then there is good chance we will see a reversal in price. If price gaps and there is not an inventory of unfilled orders to stop price, then we will see price run until it does hit an inventory of orders.

The chart below is an example of “fading the gap” or what we refer to at Online Trading Academy as a Novice Gap. Looking at the chart on the left, there is the creation of the Demand Zone. The area shaded in yellow was the area where buyers and sellers were in a state of balance until a point where the stock ran out of willing sellers at that price. There are probably a number of unfilled buy orders in that zone that remain, and the chart on the right shows price gapping down into that zone. The gap is a little bit hard to see on the right because the move away from the zone was so strong that it created a large green candle. We call this a novice gap because only novices are the ones selling after a drop in price at a level where clearly demand has exceeded supply. The professionals know this and they will willingly trade against these novices.

What is a gap down?

If this stack of orders was not present, then we would have had a “gap and go” scenario as price would have continued to fall in search of a strong inventory of buy orders.

Generally speaking, gaps are nothing to be afraid of once you understand how they will move with respect to order flow. That order flow is the true supply and demand that can be discovered on a price chart.

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