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

Profiting with price gaps

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.

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