Finding Gaps

Those of you who have been in my live classes or XLT sessions know that I like to trade the morning gaps. This is a period of high volatility and price movement that can offer great opportunities when traded properly. Of course, with the increased volatility comes greater risk and you should not trade this time unless you have a detailed plan on how to trade it that also includes risk management rules.

When I used to work as a trader for a retail brokerage, I learned first-hand that gaps were caused from a large imbalance between buyers and sellers. This imbalance could be the result of news on the company or sector or an economic data release that changes investor sentiment. The retail traders either place orders in the after-hours markets or they have them stack up for the brokers to fill on the open.

The broker’s traders and market makers generate income for their companies and themselves by filling customer orders. When there is a large imbalance between buyers and sellers due to an influx of one stack of orders from retail customers reacting to news, they cannot fill those orders until they find enough pending orders on the opposite side, (i.e., sell orders to match their customers’ buy orders). Prior to the open of the markets at 9:30am EST, the market makers will push prices higher or lower so that when price gaps open, it will open into an opposing supply or demand zone with orders to fill their customers’ ones.

As a trader, we can locate stocks that are likely to gap up into supply or down into demand so that we can take advantage of this novice trading. The key is to know where to look. One thing to remember is that even though the pre-market information may be showing a potential gap, it doesn’t mean it will happen. There have been several times where the gap failed to materialize even after the data showed it should.

A free source for gapping information is the NASDAQ itself. On the home page of the NASDAQ website, www.nasdaq.com, there is a section for the pre-market. By looking at the leaders in the pre-market, we can identify which stocks may gap up or down. Based on where the broad market is opening, this information can be used for excellent trades in the morning.

If you are looking for more options other than just the NASDAQ, then you can rely on your trading platform. I use TradeStation which allows me to screen for gapping stocks on their radar screen. When the market opens, the column heading “Open Gap” shows me how much a stock gapped up or down. When I compare this to the “Net Change Open” column, I can see if that stock is trying to fill the gap. You can populate this scanner with any list of stocks you would like; and by clicking on the header you can sort by gaps up or down.

Using another analysis technique called “Net Chg (C)” can also be useful. This will show you the change in price from the prior day’s close and can help you to identify stocks likely to gap before they open.

Whichever method you choose to identify the stocks likely to gap, exercise caution in trading them. Gap trading and even trading in general in the first 15 minutes of the trading day can be dangerous and should only be undertaken by experienced traders who also have a solid plan for doing so. Once mastered, this type of trading has good potential for quick profits.

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