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How To Trade Upside Gaps

We have all seen situations where a particular stock or market Index gaps up above the previous close on high volume. The question that usually follows is whether the move will continue higher or will it be reversed. The common thought we all hear when it comes to gaps is that a gap will always attempt to close and that is true for the most part. Gaps always attempt to close especially if it was created on relatively high volume.

This short article will list out some steps that you can use to find and exploit trading opportunities where gaps occur. It is just one of many trading strategies that, if used correctly, can become a reliable tool in your arsenal. The best part about it (at least in my opinion) is that you do not need any complicated technical indicators. All you need to do is be able to identify a gap and do some simple volume analysis.

To get started, lets clarify what a gap is: A gap, in its most basic form, occurs where no trades/transactions took place at that level. In other words, it is a price void.

9019107_orig

Notice how there is no trading between the two red lines? That is a gap to the upside.

Now, when a market gaps up, it is important to keep an eye on the volume as that is how you can normally tell if it is likely to reverse or go higher. That is the information you wil need to set up and execute your trade.

If the gap is large ( in terms of price move) and the volume is high, it is more likely that the gap will be tested. Gaps that are small and occur on relatively thin volume, are the ones that are less likely to reverse. As far as volume is concerned, we are talking about the volume on the gap day as compared to the volume on previous days and the day after the gap day.

There are some traders who contend that average volume is unreliable and that its better to compare volume on a day to day basis. This is something that you will have to try for yourself to figure out which is best for you but, based on my own experience, comparing volume at similar price points in the past
( a day to day comparison) produces better information that you can use to make better trades. There will be a future article on volume analysis where I will delve more into the specifics.

Now back to the gaps.

When a stock gaps up, the low on the gap day turns into price support. It is the test of this support that will tell you whether or not you should be going long or going short. Just look at this carefully:

1) If the gap low is tested on light volume, it implies that there is not enough energy to break through the gap so the low becomes support and the stock now has a high probability of moving up. In fact, some have gone as far as to standardize things and say that: if the volume decreases by 10% or more on the test of the gap low and closes above that low, then you have a buy signal.

2) The lighter the volume on the gap low re-test, the stronger the buy signal will be. Why is this? Well, since volume is what moves price, if there is no volume it simply means that there is no interest in selling below the gap low which, by extension, means that there is an increased probability that the price will reverse.

For more on this, you can study the Work Of Tim Ord in his book:

Now lets take a look at this chart:
4194561_orig
Chart of BIDU showing a Gap Retest

Now there are a number of things you need to pay attention to on this chart:

1. Look at the gap on the chart as highlighted by the two red horizontal lines.
2. Look at the test of the gap low as highlighted by the Green arrow. We know that it is a test because the bar/day in question did not close below the low of the gap day. It basically punched below it and then reversed and closed above the low of the gap day.
3. Now tuen your attention to the volume bars and look at the volume on the gap up compared to the volume on the test of the gap the next day.

If you take the time to look, you will see these all over the market on any given day and all of them present good trading opportunities.

Remember that the test of the gap low has to be:
1. on lower volume ( in fact the volume has to decrease by 10% or more and
2. the price has to close above the low of the gap day.

These two conditions will trigger a buy signal and, in this case, we can see where BIDU eventually went on to make a run up.

This is just a simple gap trading strategy that can be used to trade either stocks or directional options. Like everything else, it will take practice to get the analysis, trade set up and the execution right, but you can start by just looking for gaps in various charts and see how they are tested and compare the volume on the test.

There will be an article on how to trade Downside gaps soon.

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