Traders are always asking me about how to view the gaps and what are the trading opportunities associated with them. Well, I’m not going to give away all the secrets in an online article; you have to attend one of Online Trading Academy’s courses or the Extended Learning track to discover them, (collective sigh of relief from all students) . However, I will share one thing to watch as you are looking at to see whether the gaps will fill quickly.
Gaps are caused by large imbalances between buyers and sellers. Think of a stock that releases great news or beats earnings estimates after the stock market has closed for the day. There are likely to be an abundance of buy orders flooding in from retail traders and investors when they hear the news. Most novice traders wouldn’t even consider selling on the good news. This will cause an imbalance between the number of buy orders and the number of sell orders at the open the next morning.
When a broker or market maker receives that large number of buy orders, they want to fill those orders to receive commission. You will typically see the bids and/or offers move upward just before the open so that when the market opens it will open near to a prior supply level. This supply level will have plenty of sell orders to fill the retail buy orders.
Once the retail buy orders have been filled, there is often a lot of supply left and prices begin to close the gap. In our classes, we teach that a trader should center their decision to buy or sell based on the price in relation to supply and demand. Combining gaps with the supply and demand knowledge offers a powerful price direction indicator.
Looking at the intraday chart of Biogen, we can see that price opened up just short of a supply zone. The large amount of buying pressure that caused the price to open higher was immediately absorbed by the selling pressure at supply. A trader watching this would have been able to capitalize on the quick drop in price.
It is important to check and see if price is gapping into supply or just above it. If price had gapped above the supply zone, the gap would have been less likely to fill and a rally would have likely ensued.
The opposite reaction occurs if price gaps into, but not past a demand level. Looking at the intraday chart of Akamai, you can see that price dropped and moved into a demand zone.
The smart trader would have noticed that the price simply gapped down to a prior demand zone and the buyers waiting there easily absorbed the selling pressure of the amateurs and sent prices higher. Be sure to pay attention to where price gaps into and practice good risk management. Do not risk taking positions prior to the announcements and do not let your emotions get the better of you and jump into a stock before it hits a reversal point. Until next time, trade safe!
You can find out more about the stock market, and how to trade, starting with a free Power Trading Workshop at Online Trading Academy. Classes are held on a regular basis at our local financial education centers and online. Complimentary registration for an upcoming class is available here.