In war, soldiers report long bouts of sheer boredom punctuated by mindless work details, interspersed with sudden bouts of pandemonium and terror during enemy engagements. It’s during these times when those same soldiers typically point to one thing that saves them: Their training.
Similarly, when markets explode in their own way, it is the well-trained and properly prepared traders who won’t just survive, but thrive. Such price shocks typically occur because unexpected news or data were introduced into the mainstream, shifting the market’s current understanding and future price expectations. In stocks, this shift can have deep consequences for supply and demand, causing a significant gap between the previous day’s closing price and the current day’s opening price.
Sometimes, these gaps are fleeting opportunities — for the vast majority of traders, they only are obvious after it’s too late to exploit them. Other times, though, the shock comes in the wake of an extended period of price stability, and the pressure release results not just in a gap open, but an extended surge in the direction of the dominant trend. These conditions can offer a golden opportunity to participate in the move while other traders run for cover.
The downside, though, is that trying to chase such price moves can be like trying to chase a dragon’s tale — always beyond your reach until it’s too late and opportunity is lost. But if you are prepared and have a solid understanding of the dynamics in play, then you can emerge profitable.
Behind the run
After a stock’s price has been in a confirmed trend for a certain period, it attracts greater interest among market participants. This increased interest, when accompanied by simultaneous trading activity, results in the formation of gaps.
A gap is said to have formed in a bullish market if the lowest price of the instrument in one period is visibly higher than the highest price of the instrument in the preceding period. The opposite is true for a bearish market in which the highest price of an instrument in one period is visibly lower than the lowest price of the instrument in the preceding period (see “Apple gap").
Gaps also can be caused by increased interest in a stock because of a related incident, announcement or news. These events attract a lot of public attention toward the instrument, the attractiveness of which is amplified by the presence of a trend. The combination of the trend and the event often results in a sudden surge of volume and interest. In this way, gaps validate the instrument’s current trend.
A price gap is classified as a runaway gap if it follows a visibly confirmed trend. If a confirmed trend is in place, it doesn’t have to be strongly bullish or bearish, but it has to be distinctly visible and not include any sideways movement. The gap validates the existing trend and highlights a persistent interest in the instrument in the market.
A runaway gap usually is found around the middle of a trend after price already has made a forceful move in a visible direction. This is a healthy confirmation that price will continue trending, resulting in even more interest in the security among the investing public. Similarly, it’s after these strong moves when many traders who have been on the sidelines waiting for a better entry or exit point decide that if they wait any longer they will miss the trade.
Once runaway gaps have developed, they are identified as points of support and resistance within the trend. After price breaks away, once it retraces to fill that gap, it’s a sign that the trend is weakening, potentially suggesting a trade exit.
Yet another twist on gap analysis is the exhaustion gap. If a trend has been in place for a prolonged period of time and what appears to be a runaway gap forms on extreme volume, it could signal the end is near. Unfortunately, there is no clear and objective way to distinguish a runaway gap from an exhaustion gap — practice and familiarity with the stock being traded are key (see “Out of steam”). However, a general rule of thumb is the longer a trend persists, the greater chance a gap may signal a last-gasp end to the move.
Rules of the game
Whether price erupts into a runaway gap from a trend in motion or out of a period of price consolidation, the safest way to trade runaway gaps is to take note of when the actual gap occurs, then wait for price to pull back. For bullish trades, after the bullish runaway gap is formed, wait for the first trading day where the intraday low trades under the previous two trading days’ intraday low, then take a position when price resumes trading above the intraday high of that same day (see “Gap and run”).
Conversely, for shorts, after a bearish runaway gap is formed, wait for the first trading day that trades above the previous two days’ intraday high and then take a position as the price resumes its downward decline when it passes that trading day’s intraday high.
Set your stops at no more than 5% away from your entry price and take profits by selling half your position when you have a profit of at least 10% and then move your stop to breakeven. At times, price can be volatile after such a move and, though runaway gaps have enormous profit potential when you catch the move just right, discretion is the better part of valor when managing risk. Remember to be prudent with these types of trades and take quick profits with half your position as the stock moves in your favor, managing the remaining half as the stock climbs higher.
For example, the remaining half of the position should have stops adjusted under the subsequent intraday lows in a bullish trend or, if a bearish trend, placed just over subsequent intraday highs.
Runaway gaps provide some of the most promising trading opportunities. With the trend strengthening, you can establish a trade with tight risk control but a high potential for profit. Another advantage is that gaps are relatively simple. A quick look at a price chart will tell you whether a gap occurred. Additionally, gaps have risk-control measures built in — they offer reliable and obvious levels where you can place stops. However, gap trading is not mindless. It takes patience and experience to tell a runaway gap from an exhaustion gap, and proper trade management requires flexibility and constant monitoring.
As with all trading patterns, a runaway gap isn’t foolproof, but understanding the principles involved while putting yourself on the side of momentum gives you a reliable way to spot, track and enter a trade when news shocks and volatility drive many traders to cash.
Billy Williams is a 20-year veteran trader and publisher of www.StockOptionSystem.com, where you can read his commentary and a report on the fundamental keys for the aspiring trader.