Most of the time stocks do not make big moves up or down. And we as traders generally have to try to buy and sell a lot of small movements in order to make a significant amount of money.
There is an exception to this, however. When the market opens in the morning, it is not uncommon to see huge moves in one direction or the other.
Often these huge moves seem to jump across the screen and create “gaps”.
If you know how to trade these moves, you can make a nice chunk of change in very little time. But it can also be scary to try to buy or sell during times when the price is making such violent moves.
So in this article, I'm going to explain how to reduce risk and increase rewards while trading gaps.
A “gap” by definition is any case where the price of a stock opens above it's previous close or below it's previous close.
Here is an example using the Van Eck Vectors Junior Gold Miners Index (GDXJ):
Gaps are created because sometimes there is a lot of demand that builds up overnight while the market is closed or because there are a lot of people who decide to sell overnight.
When market makers then show up the following morning, they try to sell at a high price at the open or buy at a low price at the open. This causes the price to have extreme moves up or down and then to top or bottom right afterwards.
Most gaps eventually “close”. In other words, the price usually returns to the close of the previous candle. But not always.
So how do you know when a gap is going to close and when it is going to continue in the same direction?
The best thing to do is to pay attention to the candlesticks. If these show that the price is topping or bottoming, it's time to get into the trade.
For example, look at this chart of the SPDR S&P 500 ETF (SPY):
In this example on the four-hour chart, the price gapped up at the open of March 1. In the first four hours, it continued rising. At this point, it was too soon to enter a short trade because there was no way of knowing how long it would take for the trend to reverse.
However, the following four hours produced a “shooting star” or upside-down hammer candlestick. The next four-hour candle then confirmed this pattern with a move lower.
At this point, it would have been fairly safe to assume that the gap was going to close. So a short trade could have been entered at the close of the third candle (at about the middle of the following trading day), with a take-profit at the bottom of the gap.
Within the next six or seven candles, the gap was closed at a profit of around $2 per share.