Gaps are a category all unto themselves. Lets discuss gaps in two parts. First we will look at what they are, why they happen and what the concepts are. Next we will look at some chart examples.

A "gap" is a term used to describe the circumstance of when a stock opens at a higher price than it closed the prior day. The word "gap" refers to the gap that is left in the daily chart; the empty space from yesterday's close to today's open. Gaps can be either up or down. They can happen to all stocks, listed or Nasdaq.

The gap is measured from the prior day's 4 p.m. closing price to the current day's 9:30 a.m. opening price, all in Eastern Standard Time. The post market activity and pre market activity do not affect the "gap" for our purposes. Stocks can trade after market hours through ECNs (Electronic Communication Networks), until 8 p.m. and pre market starting at 8 a.m., but this is currently not considered to be "normal" market hours.

For example, stock XYZ closes at 4 p.m. EDT at 37. It trades in after market hours up to 38. The next day at 8 a.m. EDT it starts trading at 38.5 and trades up to 39.5. By 9:30 the stock is all the way back down to 37.10. The "gap" as we measure it is only 10 cents. All those post and pre market trades do not matter. The stock traded, and people made and lost money, but the gap is not affected.

What causes gaps? Usually it is news driven. Individual stocks can gap up or down due to news such as earnings reports, earnings pre-announcements, analysts' upgrades and downgrades, rumors, message board posts, CNBC, or key people in the company commenting or buying/selling the company stock.

Groups of stocks or the whole market may gap up or down due to various economic reports, news on the economy, political news, or major world events (most recently is the large gap down from the Sept. 11 incident). This news can cause many individual issues to gap with the market. Many big name stocks move very closely with the market. Some may be in the sectors that are most affected by the news.

Whatever the exact reason, gaps are the result of some kind of event happening while the market is closed. The result is the buying or selling pressure at the open of the next day, which will make the stock open at a different price than where it closed. Why are they important? This sudden move by a stock, the sudden change in demand, is often the beginning of a major move. They are swing trading strategies that capitalize on entering after a gap, and guerrilla tactics that capitalize on one or two day moves after a gap.

Here are some concepts and general rules about gaps. First, we generally never buy a large gap up at the open or sell short a large gap down at the open. When market makers have the chance, they will often exaggerate the gap. Also, large gaps are already extended, making the play risky. We tend to "fade" the gap initially, if played at all. Fading means to play the stock to come back in to where it was. Fading a large gap up would be to go short the stock as it trades down after a large gap up.

After the initial move, the charts must be looked at along with the amount of the gap, and the share price of the stock. Small gap ups that gap over resistance can be watched for long entries. Large gap ups that gap into resistance can be watched for short entries. What is "large" or "small" and what is resistance is all a matter of chart reading and interpretation, but there are some rules we will be looking at.

Small gap downs that gap under support can be watched for short entries. Large gap downs that gap above support can be watched for long entries. What is "large" or "small" and what is resistance is all a matter of chart reading and interpretation, and again, there are some rules we will be looking at.

The concept of gaps is a very difficult one for most traders, even those with considerable experience. They are a strategy all by themselves, and are part of many other strategies. We will next look at a few examples. While this cannot serve to fully educate you on the topic, it can get you started thinking correctly about a big part of the trading day: the opening.

While there are many strategies involving gaps, let's look at a few here.

As a rule we like to buy strength and sell or sell short weakness. This is the preferred play. There is an exception however. Below is an example of shorting a strong stock.

chart courtesy of Mastertrader.com

The nicest plays are where a stock gets extended and then gaps in resistance (for a short). However, there are times a stock may not have a resistance area, like when at new recent highs. Why short a strong stock? Well, normally we would not. But this stock is over extended. Look at the 20-period moving average (red). Notice how far away we are now as compared to in the past two months. Notice that there were six days up in a row, all of them since the breakout from the base, or consolidation area on the daily chart. Look at the increasing volume as shown by the last three green bars on the daily chart. Now, on the last day shown, the stock gaps up. That is the key. This is known as a Novice Gap. The latecomers are deciding that now is the time to buy. This is where the opportunity is, on a day like this on the gap up. This is a guerrilla type tactic that should be used for the day, or possibly one overnight.

Below is another example on a long play.

chart courtesy of Mastertrader.com

Here again, look at the distance from the 20-period moving average. There are five days down in a row. One thing missing here is the big increase in volume on the last day. However, look at the size of the gap. This is a large gap after five days down.
Here is a slightly different play shown below in KANAD.

chart courtesy of Mastertrader.com

Notice all the same things here. The distance from the 20-period moving average, the number of days up, and the increasing volume are all present. Here, the stock does not gap up in a novice fashion, but rather it gaps down (60 cents). This is known as a Professional Gap. Profit taking sets in and the stock drops. This stock opened on its high of the day. We shorted this stock at 28.40 with a stop at the high of the day, 15 cents away. We took half profits at our first target 27.23 and are trail stopping what will hopefully be a swing trade.

There are two nice things about playing gaps that many traders like. You can usually have very tight stops, (or can pass on the ones where you do not), and you usually get some results fairly quickly. Often reversal time (10:00 A.M.) brings some results.

Gap Reversals

These methods work best for a two or more day trade, known as a position trade. This method seems to work best on NASDAQ stocks. In trending markets, it has an excellent accuracy rate of more than 80%.



Bullish Gap Reversal Guidelines or Requirements

1. A stock that has a consistent trading range of at lease 1.75 points.
2. Stocks that have a decent spread. Although a stock is often entered with an ECN, a trader does not want to be severely hurt by the spread. Stocks should also have an adequate number of market makers to allow for cushion.
3. The stock should be down at least two days in a row before it becomes a consideration.
4. Open of the current day MUST be in the top 25% of the day's price range.
5. Close of the current day MUST be in the bottom 25% of the day's price range.

Next trading day's ACTION

1. If the stock gaps open to the downside and then begins to rally back, buy it at 1/8 to 1/4 above the previous day's low. If a trader misses that entry, buy when it trades above its first one-half hour high. Market makers should be buying the stock as well.
2. Stop/loss should be 1/8 to 1/4 below the current day's low.
3. Look closely at the chart to determine an average and reasonable profit amount, or decide on a dollar amount that is reasonable for the stock and get out at that point. If the market and/or sector remain strong, a trader is in very positive territory and should hold it for the next day or two.

Bearish Gap Reversal Guideline Requirements

1. A stock that has a consistent trading range of at lease 1.75 points.
2. Stocks that have a decent spread. Although a stock is often entered with an ECN, a trader does not want to be severely hurt by the spread. Stocks should also have an adequate number of market makers to allow for cushion.
3. The stock should be up at least two days in a row before it becomes a consideration.
4. Open of the current day MUST be in the low 25% of the day's price range.
5. Close of the current day MUST be in the top 25% of the day's price range.

Next trading day's ACTION

1. If the stock gaps open to the upside and then begins to fall back, sell it short at 1/8 to 1/4 below the previous day's high. If a trader misses that entry, sell it short when it trades below its first one-half hour low. Market makers should be selling the stock as well.
2. Stop/loss should be 1/8 to 1/4 above the current day's high.
3. Look closely at the chart to determine an average and reasonable profit amount, or decide on a dollar amount that is reasonable for the stock and get out at that point. If the market and/or sector remain weak, a trader is in very positive territory and should hold it for the next day or two.

Morning Star Gap Reversal Guideline Requirements

1. A stock that has a consistent trading range of at lease 1.75 points.
2. Stocks that have a decent spread. Although a stock is often entered with an ECN, a trader does not want to be severely hurt by the spread. Stocks should also have an adequate number of market makers to allow for cushion.
3. The stock should be down at least two days in a row before it becomes a consideration.
4. Open of the current day MUST be in the top 25% of the day's price range.
5. Close of the current day MUST be in the bottom 25% of the day's price range.
6. Above average volume on the current day is preferable.

Next trading day's ACTION

1. If the stock gaps up on the open (at least 1/2 point to one point) above yesterday’s closing price, buy it immediately. If a trader misses that entry, buy when it trades above its first one-half hour high. Market makers should be buying the stock as well.
2. Stop/loss should be 1/8 to 1/4 below yesterday’s low.
3. Look closely at the chart to determine an average and reasonable profit amount, or decide on a dollar amount that is reasonable for the stock and get out at that point. If the market and or sector remain strong and a trader is in very positive territory, the trader should hold it for the next day or two.

Evening Star Gap Reversal Guideline Requirements

1. A stock that has a consistent trading range of at lease 1.75 points.
2. Stocks that have a decent spread. Although a stock is often entered with an ECN, a trader does not want to be severely hurt by the spread. Stocks should also have an adequate number of market makers to allow for cushion.
3. The stock should be up at least two days in a row before it becomes a consideration.
4. Open of the current day MUST be in the low 25% of the day's price range.
5. Close of the current day MUST be in the top 25% of the day's price range.
6. Above average volume on the current day.

Next trading day's ACTION

1. If the stock gaps down at the open (at least 1/2 point to one point) below yesterday’s closing price, sell it short immediately. If a trader misses that entry, sell it short when it trades below its first onehalf hour low. Market makers should be selling the stock as well.
2. Stop/loss should be 1/8 to 1/4 above yesterday’s high.
3. Look closely at the chart to determine an average and reasonable profit amount, or decide on a dollar amount that is reasonable for the stock and get out at that point. If the market and/or sector remain weak, a trader is in very positive territory and should hold it for the next day or two.