Today's Quote: “Optimism is the foundation of courage." Nicholas Murray Butler.

Yesterday we gave you an introduction to some basics on gaps. Today we would like to give you some more concepts of working with gaps. Gaps are a difficult area to learn. They are unique opportunities in the market and form the basis for many strategies or entries to strategies. Please understand that this learning section of the daily trading letter is meant to highlight some important concepts for newer traders. It cannot begin to substitute the training needed to actually trade one of these concepts.

While working with gaps, you will continually be categorizing the type of gap. One of the first things you will need to determine is if the gap you are looking at is what we call ‘excessive’. The concept of an excessive however is not nearly as simple as assigning a certain dollar amount or a percentage of the stock price to the gap. A 3% gap up may be excessive in one case, and a 5% gap may not be excessive in another case. That may be due to the difference of volatility among different stocks, but more importantly, it will depend on the chart pattern involved. The recent short-term and long-term price pattern of the stock matters very much in making this determination.

Consider two different stocks that are each gapping about the same percentage amount. The first stock has rallied on the daily chart to a resistance area and then gapped down; it's a Professional Gap into the prior bar and may be a playable short. The other stock that has also rally on the daily chart and then gapped up to a resistance area; it's a Novice Gap that may also be shortable as it made an excessive exhaustion move that is far away from the 20MA. Even though the gaps are similar in size, the latter gap is likely to be filled and the former is not; and yet both gaps are likely to cause the same trend reversal.

The longer-term pattern of the stock also plays into the picture of whether or not we feel a stock is gapping in a “professional" manner or a "novice" manner. The size of the gap, and whether or not the gap is landing short of, or beyond, support or resistance will also make a big impact on how the gap may be played.

Gaps are part of all of our Trade for Life™ seminars and also an integral part of our everyday routine in the Trade for Life™ Live Trading Room.

Points to consider when evaluating a gap:

1. Where is it gapping to in terms of support and resistance (over/under/into). A Novice gap into support or resistance is likely to fill and reverse the prior trend (+ 1 Point); and a novice gap beyond support or resistance is less certain (no points). A Professional gap over resistance or under support is not likely to fill, but is likely to reverse the prior trend (+ 1 Point).
2. Where is it gapping from - Short Term. Consider the pivot pattern on the 15- & 60-minute charts over the last few (3) days. Novice gaps that are extended intraday (+ 1 Point). Professional gap that is reversing the intraday pattern and has good shock value (+ 1 Point).
3. Where is it gapping from - Long Term. Consider the pivot pattern on the daily chart over the last few (20) days. It may help to color in the missing (gapped) bar and then analyze the developing chart pattern. Novice gaps that are extended 3 or more days (+ 1 Point). Professional gap that is reversing an extended (3 or more) daily pattern (+ 1 Point).
4. Gapping size. It is best if the size is just large enough to do the most damage to the short and long term price patterns (i.e., provide good shock value, + 1 Point).
5. Relative weakness or relative strength compared to the broader market indices. Novice gap in the same direction as the market (+ 1 Point). Professional gap in the opposite direction of the market (+ 1 Point). Generally you want to have your trade in-synch with the broader market trend; but often the best gap plays tend to be on-their-own and trading against futures (shock value).

Gaps that have 4 for more points are considered Tier 1 plays; and these are very likely to run from the open. Gaps that have 3 Points are considered Tier 2 plays and are likely to run after a brief shack out move. Tier 3 plays have 2 or fewer points are best placed on a watch list for a setup.