For stock trading, a gap is simply an opening price that is either higher or lower than the previous closing price. A gap can occur on any time frame, from the short intra day time frame to the longer weekly or even monthly time frame. For our purposes, we will consider the daily time frame.
Some additional details on gaps will qualify the different types of gaps. A gap that occurs within the previous day’s price range is usually not as significant as one that occurs outside of the previous day’s range. Think about it, a larger gaps implies higher volatility and a better chance of a profitable trade and if you are not careful, a larger loss!
What causes a gap? When there is an imbalance between what buyers are willing to pay versus what sellers are willing to accept, market makers will move price to a point that balances out the demand and supply. Gaps in price often occur when a company comes out with better than expected earnings or unexpected positive news. Information like this will often drive a stock price higher on the open relative to the previous day’s close.
On the other hand, if a company announces poor earnings or an unexpected lawsuit going against the company, the company’s stock price can easily gap down on the open.
As a trader, your job is to access the likelihood of either a continued price move in the same direction as the gap or a reversal. One way to accomplish this is to do nothing. That is right, do not trade.
Instead, let other traders do the work for you. For stocks that gap outside the previous day’s price range, what I do is let the stock settle in to a trading range. I’ll give the stock a hour of trading then wait for a break either above of below the first hour’s trading range before taking a position. Assuming the stock drops below the first hour’s trading range, I am looking to take a short position in the stock.
With a short position in the stock, I will then place a buy stop order above the first hour’s high. This acts as protection against an unexpected move in a direction that is not profitable for me. At this point, I am interested in the stock moving favorably and doing so quickly. Assuming this example of a short position stays profitable, I will move my buy stop price lower as the stock continues to move lower. If not, the stop order takes out the position.
This is just one method of trading gaps in stock price. Sometimes the best course of action is to do nothing. If the stock has not made an obvious trading range in the first hour, then consider either waiting until a trading range has been carved out or just skip the trade altogether. Capital preservation for traders is of utmost importance. Skipping a trade means you get to come back later with your money.