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Gaps - My Favorite Trading Set-up

Posted by Pete Stolcers on September 16, 2008

In today’s option trading blog I will discuss gaps. If you believe in efficient market theory than everything is priced in to a stock every moment and a move is a random, unpredictable event. As the theory goes, you should just put your money in an index fund and a bond fund because you can’t outperform the market. In the era of full disclosure, that is more the case now than ever. Information flows freely and there are fewer “secret handshakes” than ever. I don’t believe in the theory and I am able to find opportunities on a daily basis. However, let’s say that I did believe. What happens when the unexpected ocurrs – a gap.

The market scrambles to assess the news and to weight the importance of the event. All of a sudden, imbalance and chaos exist. This is the environment I seek. The market hates uncertainty and the reaction can be very telling. Down gaps are my favorite because they can lead to big drops. Here’s my angle.

I define a bearish gap as a stock where the high today is below the low from the prior day – it is a true gap. If the low price for a stock yesterday was $42 and the high today was $41, it qualifies. The move was so pronounced that the stock could not even rally to $42 intraday. This tells me that there’s a crack in the dam and the stock is weak.

There are many keys to trading gaps, here are two. First of all, where is the stock in relation to the 52-Week range? I’m much more interested in a down gap on a stock in the upper quadrant of the 52-week range than a stock that has been in a free fall. Why? Because everyone is long and panic and profit taking can easily set in. For that same reason, I’m more interested in stocks with high P/E ratios and “lots of promise”. If the resistance level is defined (long term horizontal) I can be pretty sure those highs will not be tested soon. Option traders… do you see the implications?

The second key is to watch the reaction the second/third day. If it was a big gap and it filled in easily, the news may not have been material. If the stock tries to bounce and “fill” but it fails and makes a new low on a steady drift lower, it has more room to fall. You should always read the news and determine the reason for the gap. An analyst downgrade means nothing, those gaps will fill. A material change in earnings guidance… now that move could have legs.

I can make a living just trading gaps. I have a scan that shows me gaps that are up to 4 days old. Sometimes the older the better. If you are a OneOption subscriber, click on the Scanner and try it out. You will get a one day pass. If not, Register and try all of the research free (including 5 reports). The Scanner will show you at least 300 new stocks each day and the charts are integrated.

What’s your favorite set-up? Tell me and I’ll share my thoughts.

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Posted in Analysis - Technical, Fundamental, Market

Option Trading Comments

  • On 06/29, jack holland said:

    Good Blog-My favorite also as very consistent and "earn on the turn" possibilities for room to run.

  • On 06/29, Tom said:

    This is a much talked about subject.  I have read a lot on gaps and all the strategies and it gets confusing.  I agree that they are playable if you can determine the "quality" of the gap.  If you can determine the news factor they can be great reversal plays.  Sometimes I might think the news isn’t so bad, but the market disagrees and sends prices lower. It is a good idea to keep previous gaps from days or weeks ago on the radar screen to see how prices react at those points.  I prefer the reversal type, since many times I have expected more downside after the gap only to see price trade sideways for weeks.  An example of the gaps I like would be the recent gap down on Phelps Dodge.  It was the usual Wall Street nonsense of knocking down a stock because of a buy out situation. After a few days of stabilizing, on Tuesday I bought a few July 80 calls for $175.  Early today they have been trading between $350-$400. I would not be surprised to see the gap at least fill above $82.  The options could be worth $450 or more. To me this was a good opportunity since this stock has been in play for a long time with a lot of volatility.

  • On 06/29, Pete Stolcers said:

    Great points. Know the quality of the gap. Big gaps with lots of excitement attract too much initial attention. You might be able to trade the initial move, but you have to be small and nimble. If you wait for the momentum players to get "shaken out" and the dust settles, the true reaction to the news will take shape. That is normally the better trade. I personally have 8-10 day old gaps that I trade, but they require much more interpretation and "feel" so I don’t include them in my Scanner.

  • On 06/29, Jon T. said:

    I have had only limited success with trading gaps.  I’m still looking for that "key" that will increase my win rate.  Perhaps the things that Pete looks for will help.<br><br>Also, I thought I would share the following from a weekly options trading newsletter that I subscribe to.  It appears to be useful information for trading down gaps during earnings season:<br><br>"Get ready for second quarter earnings announcements. If it’s anything like the first quarter, expect plenty of volatility. In fact, the huge moves that many stocks made in the first quarter, in response to their earnings announcements, warnings, or forecasts, were nearly unprecedented. Many stocks gapped 10% or more after those announcements. <br><br>We recently performed some studies on this phenomenon and reached one tentative conclusion: if a stock drops 10% or more following its earnings, then it’s likely to drop even farther over the next few weeks. Specifically, the average stock fell by another 6% over the next three weeks—usually plenty of room for a put purchase to make money. <br><br>Ironically, one cannot say the same thing about upward gaps, coming on the heels of positive earnings reports. The results there were much more spotty, as only about 40% of the stock continued to gain over the next three weeks, while the remainder slid back. Perhaps investors get too excited about positive earnings and "overbuy" the stock on the first day, leaving little or no room for further advancement." <br>

  • On 07/01, Matt said:

    My favorite is the pullback to the 20 ema on a breakout. If the stock is strong, it’ll bounce right off.  I stick a 2-3% trailing stop behind it and have the trade run on autopilot.<br><br>The work in finding and executing these is just plugging and updating the information in my QuoteTracker Alerts...<br><br>But a pretty solid trade.  With about 50-100 stocks in QuoteTracker, you find at least one or two of these a week, and they add up!

  • On 07/13, Tom said:

    Do you think there will be a play on CREE?  They dropped 20% today on news that their revenue numbers will be slightly below the low range of estimates.  Seems like a big punishment.<br><br>Maybe it’ll bounce, at which point the "tree will be shaken" like you mention elsewhere?  If so, maybe it’s a good time to buy puts?  For example, let’s say the price jumps to $20 and the July puts drop to, say, $0.20… so it’s like buying a lottery ticket w/ 1 week to go.<br><br>Just curious to see how/if you would play this.<br><br>

  • On 07/14, Pete Stolcers said:

    With regard to Matt’s comment on CREE. That tree has not been shaken. It has been cut down and sawed into little pieces. I would not play it until it has formed a flat horizontal base over 2-3 months and a bounce has broken above a short term resistance level. It will be dead money for a while.

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