From the October 01, 2012 issue of Futures Magazine • Subscribe!

Profiting with price gaps

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. 

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