How to Trade Gaps in Stocks

 

Many (many) years ago when I first started intraday trading, I heard the expressions ‘Fade the Gap” and the so called rule that All Gaps Fill. What a load of bunk that was. Sadly there are still some who teach and preach the gap fill as if it were gospel.

First, let’s understand what a gap is. By definition if the price of the open of the day is different than the closing price of the prior day we have a gap. Example yesterday’s close was 1331.5 and today’s open is 1331, we have gaped down by .5

How to Trade Gaps

The rational for believing that all gaps will fill is that the gap represents a lack of trading activity at that price level. Neither support nor resistance, but rather a void that will act like a vacuum and suck the price towards it.

But wait one minute here, with the advent of overnight trading and the globex how can we with certainty say there was a lack of activity. With the electronic trading hours it could very well be that there was some, none or tons of activity inside the gap.

There are in fact 2 types of gaps, and each acts the complete opposite of the other.

How to Trade Gaps in Stocks

So let’s do away with this myth, and quick fix trading approach that has many traders getting hammered as they try to fade a gap, that is simply not meant to be faded.

Market Profile theory suggests that there are essentially 2 types of traders that make up the market, any market. Day time traders, these are opportunistic traders looking to make daily profits are not concerned about larger trends. And ‘Other Time Frame’ traders, those who trade for any period longer that a single day. We like to refer to these as institutions… the bigger money

Now we must evaluate a gap in the context of market profile, and ask the question “ was his gap caused by day traders (small money) or the institutions (big money).

The answer to that question will tell us whether the gap is an imbalance gap or a professional gap.

A professional gap as the term implies was created by professional traders or institutions. The imbalance gap… well you guessed it by the smaller day traders.

Imbalance gaps tend to reverse and fill within the 1st 30-60 minutes of trading, and as the old saying goes, you can “fade the gap”. Which means; to take a trade against the direction of the gap. Go long if we gaped down, and go short if we gaped up

What about a professional gap? That is an entirely different story. The rule here becomes don’t trade against the big money. If the institutions were responsible for creating the professional gap then we must respect the impact they have in the market, and trade with and not against them. That means to take trade in the direction of the gap. Go long if we gaped up, and go short if we gaped down

The final part in this equation is how to tell the difference between a professional and an imbalance gap. To do this we must be a student of Market Profile Theory and understand the difference between markets that are building versus losing value.

For more information on how to trade gaps, watch these videos