What are gaps, why do they occur, and how can you profit from them?

[MC]

What is a gap?
A gap is shown on the charts any time you have price open outside the prior time period's high or low.
The below section will go into details on why gaps on big volume are significant and how you can take what I'm teaching and use it to recognize the psychology behind those moves. There will be small gaps or gaps on low to normal volume. These are events of no interest to us. It's the gaps on abnormal volume that should catch your eye and make you want to know what they did that for. Bottom line...large volume is the pros at work, our job is to realize why they are moving that many shares and follow their lead.

Bigger notable Gaps are used for 2 purposes...

1) A breakaway gap moves fast and is used to eliminate concerns of supply slowing the run. The breakaway gap is used so they can accomplish 2 things. One is to lock OUT new shareholders from playing along because it's "too high". The 2nd thing is to lock IN people that are in the red, which avoids weak hands selling into their rally. This elimination of supply ensures a continued powerful move. This is generally done on a beat up play once big money have their fill of cheap shares. They could however use this to panic people into selling, using peoples greed against them on all time highs. The latter is a way the pros could buy high knowing they will soak up the float and sell higher. This is very rare in my experience however, pros don't like to pay a premium. (HINT) Look for any pullbacks to be UBER light volume if it's a legit breakaway gap. This could be played by trying to get in as close to the low of the gap as possible to ensure a tight stop.

2) Any other gap would be used by pros to hide their own supply trail. These gaps would create early excitement as well, but in this case to sucker unsuspecting traders in. (HINT) This type of gap tends to have the next day close lower on fairly big volume. Often you will see a retracement and then a test of the prior highs on UBER light volume showing the professional money has no interest at paying the current price. A downtrend commences till the pro money buys back in. This could be played waiting for that test of highs and then fading the move once volume ticks up showing emotional trading.


Here's a good example of a short I called using a weak gap. It was a HUGE gap so "how could that be weakness". I was told I was crazy for thinking of shorting, despite telling people to wait for the breakdown. Sometimes you need to be cautious no matter how bullish it may seem.


Enjoy, good trading.

[Fibman2005]

I'm seeking your advice/knowledge on how to play Rimm with gaps. How do you use volume, supply and demand, as well as other technicals to play Rimm now (short term). I'd like to play a bounce on Rimm, but noticed it had trouble breaking through its most recent gap down. How do you tell if it will break through the gap or not? Will it have enough strength to break through its second to most recent gap where it fell from 142 to the 120s?

I've always played gaps as support and resistance, but never tried to guess whether a stock would pull back and fill the gap, or break through the gap, etc. Thank you!

[MC]

Originally Posted by Fibman2005

I'm seeking your advice/knowledge on how to play Rimm with gaps. How do you use volume, supply and demand, as well as other technicals to play Rimm now (short term). I'd like to play a bounce on Rimm, but noticed it had trouble breaking through its most recent gap down. How do you tell if it will break through the gap or not? Will it have enough strength to break through its second to most recent gap where it fell from 142 to the 120s?

I've always played gaps as support and resistance, but never tried to guess whether a stock would pull back and fill the gap, or break through the gap, etc. Thank you!

Well the gap was rather large, but RIMM has a habit of filling gaps. Not that it's ever a guarantee of course. And how could the rabid bounce off the 200ma be ignored I guess is what I'm wondering. I don't see anything specific other than the 200ma and some seemingly nice buying pressure. My hunch was to shake out, but thats JMHO.

You have the right idea on gaps as S&R also. Big gaps tend to shoot past a level that would have provided support or resistance. It's done intentionally and mark that level as it will come up again in the future.

[trustdnb]

Here's the summary of a study I just completed about opening gaps on the S&P (SPY). The study is designed to test the propensity of gaps to fill on the day of the gap, based on 1) the "zone" in which the gap opens and 2) the direction of the market the day before the gap.

The zones are lettered from A to F on the left and each represents the following:

Zone A - Opens above the high of the prior day.
Zone B - Opens between the high and the top of the real body (i.e. inside upper wick).
Zone C - Open inside the top half of the real body.
Zone D - Open inside the bottom half of the real body.
Zone E - Open inside the lower wick.
Zone F - Opens below the low the prior day.

The other variable is the prior day's trading direction. As the numbers show, this is an important consideration when playing gaps.

I have listed the Sharpe ratio, the Profit factor and the Win % for 3 different trade strategies:

1. Long at the open, exit at close.
2. Short at the open, exit at close.
3. Fade the gap, exit at gap fill.

I'll let the numbers speak for themselves, but you should note that some strategies play out very differently in their propensity to fill versus their propensity to close in that direction.

For instance B area gaps following an up day (continuation gaps) are clearly the best trades (short). They tend to fill at whopping 90.3% of the time and close lower 57% of the time. Even better, gaps that open in this zone can also be profitably held (short) for bigger targets.

Quite another story however, D area gaps following a down day tend to fill 84.4% of the time (short), but holding the same trade through the close is barely a breakeven strategy. Holding too long here would be deadly as you will tend to give back most of your profits.

Finally, these results represent perfect trades with NO STOPS. You should use this info only to understand the basic tendency and likely direction of a gap day, not as a complete trading system.

[MC]

WOW...great research trust. You're welcome to the promoted TB title of "Backtesting Bandit" if you want it. You seem to like running the stats and the title fits.

Let me know if you want the title...I'm serious. You bring allot of skills to the table.

[trustdnb]

Originally Posted by MC

WOW...great research trust. You're welcome to the promoted TB title of "Backtesting Bandit" if you want it. You seem to like running the stats and the title fits.

Let me know if you want the title...I'm serious. You bring allot of skills to the table.

Alright, an official TB Title! I always dreamed of this day, but dared not hope. *tear*

[cire2222]

nice results. thanks for the back testing!

[MC]

Originally Posted by trustdnb

Alright, an official TB Title! I always dreamed of this day, but dared not hope. *tear*

LOL...it's my honor to dub thee a bandit.