Many traders have a plan to include gap strategies as part of their trading. Gap plays can be attractive because these stocks sometimes move a “week’s worth” in a few minutes. Of course, that can be a bad thing if you are on the wrong side of the trade. The problem is that while they are attractive, most traders lose on gap plays. There are many misconceptions and just plain fallacies about stocks that gap. A week long seminar could be given on trading gaps and all the possible strategies. This lesson cannot begin to scratch the surface. However, for those learning some of these strategies, we can try to address some of the common questions.

Once some gap strategies are learned, many traders find that they become inconsistent on the proper entry. Every strategy comes with its own entry, but as some plays blur together and various entries can offer different risk-reward parameters, many traders find they have the right play, but can’t find the right entry. For this lesson and next we will look at a couple of extreme examples of gaps and entries.

Here is a general rule. The more ‘shocking’ the gap (shocking makes for the best gap), the more AGGRESSIVE should the entry be. The more uncertain you are of the gap being a good strategy, the more you should defer to a HIGHER time frame for the entry. Below is a daily chart of SUN MICROSYSTEMS INC (JAVA), showing a gap on the last bar that we call a ‘monster gap’. This was a trade done in the VCM Proprietary Trading Room.

As gaps go, this is as about as good as it gets. The day before the gap, the stock traded with a wide green bar and broke out above a recent trading range. The next morning, the stock opened under the green bar. EVERY trader who bought this stock the prior day, or the prior seven day for that matter, was under water big time. This is ‘shock’ value and had everyone scrambling to get out the next morning. This means we want the MOST aggressive entry possible. We want to get short as soon as the stock looks weak. Remember, even if this is a bearish gap, it could rally some or a lot at open so we cannot just short the open blindly. Never do that. Below is the one minute chart of the same stock, on the morning it gapped down, shown on a one minute timeframe.

Since the first one minute candle is green, the most aggressive entry would be to short under a prior candle or on a 55% retracement of a solid green candle. This occurred on the third one minute bar, as it traded under the second bar. The stop was the high of the second bar. The target? If you look at the daily chart you can see there was some support around the 9.20 area. Also traders covering in multiple lots would take some profit whenever a green bar on this one minute chart negated 55% of a prior bar, which happened at around 8.70. A trade like this can also have potential to be held as a swing trade. Compare and contrast this play and intraday entry to a very similar gap on Nortel Networks (NT) on the very same day. What would your entry have been on that stock?

Next week we will look at the reverse scenario, a questionable gap that relies more on the intraday entry.

Entries on Gap Plays, Part 2 of 2