# Trading after a large gap



## pavilion103 (17 February 2011)

I am interested to know how people trade large gaps in stock price. If a company gaps up like in the chart below, would you take the profit? Does this sort of a gap mean there is greater uncertainty about price action in the future or not necessarily? I've seen shares gap up and then straight back down again and am not sure what the best way to trade this sort of movement is.


----------



## tech/a (17 February 2011)

pavilion103 said:


> I am interested to know how people trade large gaps in stock price. If a company gaps up like in the chart below, would you take the profit? Does this sort of a gap mean there is greater uncertainty about price action in the future or not necessarily? I've seen shares gap up and then straight back down again and am not sure what the best way to trade this sort of movement is.
> 
> View attachment 41435




AAD
A favorite of the portfolio.

Gaps indicate STRONG effort in breaking out of a price level (In this case).
I would be/am looking for opportunities to add to this trade after the customary inside days to follow.

Gap trading is a subject on its own.


----------



## Reasons (19 March 2011)

pavilion103 said:


> I am interested to know how people trade large gaps in stock price. If a company gaps up like in the chart below, would you take the profit? Does this sort of a gap mean there is greater uncertainty about price action in the future or not necessarily? I've seen shares gap up and then straight back down again and am not sure what the best way to trade this sort of movement is.
> 
> View attachment 41435




Hi pavilion103

I look at gaps this way; on probability they will get filled. In your example, this means you need to go short as the price action will go down to fill the gap. This means you are doing a quick counter-trend trade as the price action in your example is definitely making higher highs and higher lows and so is trending up and by going short you are fighting the trend.

A big bar like this can either be a positive company announcement or it is amateurs getting too enthusiastic by getting ramped through some forum or newsletter. The former is more dangerous (but not untradable), the latter more likely to produce faster results when the traders exit.

The trick is learning to reading the price action for a possible move down. Remember, it is only probability that the gap will fill, and probablity means that sometimes you will be wrong and have to take action to minimise your losses.

I look for a strong price rejection signal (a candle with a small head at the bottom and a long tail up in the air for example). A big number like $1.40/50 could be that rejection point in your example or previous support and/or resistance (further supporting evidence for a possible down move).

IF you get that positive rection signal, you need to get in the next bar assuming it starts down close to the bottom of that previous rejection bar. 

Let's say the price action goes to $1.50 and is solidly rejected and the rejection bar stops at $1.38. 

You would get in at $1.37 (1 cent lower than previous close).

Your stop is $1.51 (1 cent higher than the previous high) 

Your profit exit is $1.18 as this is the top of the gap from what I can see.

That gives you a 1.36:1 win/loss ratio - a chance of making ~$1,350 compared to $1,000 loss (ignoring brokerage) if you risked about $10K with a 1% capital risk on $100K of working capital.

I will use leading indicators like the MACD and RSI to look for any divergence that might help with the confirmation of the liklihood of the down swing and will use multiple timeframes to support that theory. The price action is first and foremost in determining an entry decision and the MA's I use, 2nd.

You will need to watch a heap of these signals to understand what you are seeing and you should not think you have to trade every gap; many will not give you a clear entry signal and therefore you do nothing and walk away. There is always another one.

Cheers


----------



## skc (19 March 2011)

Reasons said:


> I look at gaps this way; on probability they will get filled.




What probability is that?
What is the source of that information, or is it based on your own research?
Does it depend on whether there is news or not?
Does it depend on the size of the gap?
Does it depend on volume?


----------



## Wysiwyg (19 March 2011)

Welcome Reasons.

Take a chart, any chart and it could be perceived as gap filling when price bounces off near or on the previous days high/low before the gap. This chart shows numerous gaps and some instances of price bouncing off what could also be construed as support and resistance. Price action does use historical high, low, open & close prices as a checkpoint and getting them right can be advantageous.

One could believe that AQP will fill the gap to $5.60 as a place of resistance or reduced demand.


----------



## tech/a (19 March 2011)

> I will use leading indicators like the MACD and RSI to look for any divergence that might help with the confirmation of the liklihood of the down swing and will use multiple timeframes to support that theory. The price action is first and foremost in determining an entry decision and the MA's I use, 2nd.




These are *LAGGING* indicators.
I dont use any lagging indicators at all in discretionary trading.
To trade closing gaps you would expect a close or partial close in a few periods and you would be looking to go long on the retracement.
Attempting to short a to a gap can work well with futs. Not that practical or successful with stocks.

CLICK TO EXPAND




*WYSIWYG*

The trader needs to be able to discern
Break away gaps
Exhaustion Gaps
Continuation gaps

To be in the best position to analyse gaps.
Then there is partial closure of gaps. a 50% closure is far more common for all types of gaps.


*SKC*
From my research I have found gaps fill often if an exhaustion gap
Hardly ever if a continuation gap
Around 50% of the time if a breakaway gap.

The next condition is time as over years youll close every gap.
to trade practically Id say days---after that other price/volume/pattern criteria emerge as the governing 
indicator on price action going forward.


----------



## Reasons (19 March 2011)

Thanks for your questions; always easier to follow up with detail if anyone is actually interested than to bother about too much info initially.

Wysiwyg, in answer to your question, this thread is about big gaps, not general ones that say form due to ADR form trading in the NYSE overnight such as BHP or just happen regularly in a small way in a share, I am rarely interested in those.

However, AQP is a really interesting example of gap filling now you point it out, but I have not traded it. If you have a look at the AQP chart below, most decent gaps that I have indicated with arrows get filled and remarkably the price action usually goes back down or up once filled. There are more if you look. But as per *skc's* question on probability, in my opinion only, AQP has a higher propensity to fill larger gaps than not, so I would rate the probability as good in this share if I traded an appropriate size gap and I would likely win IF I get a satisfactory entry signal and an acceptable win/loss ratio.

The sorts of gaps I like to chase are ones like CDU as shown below as the win/loss ratios can be good. CDU announced they did not have the reserves they thought they had and it crashed. The CEO is one of the best ramper's in the business and after short time they miraculously found a heap more. I trade flat levels, resistance in this case and got in once it broke above 2 previous resistance rejections. I traded the gap as shown. I took half profits where indicated in case I was wrong and the top of the big red bar was the top and got out completely on the wishfully long, amateur-hour, candle as indicated, effectively closing the gap.




So *skc*, for me it is about news and market info at times, but not always and volume is interesting to me when reading the price action correctly needs some help, but does not rate highly. It is definitely about the size of the gap (but that gap size varies greatly depebding on the situation (I will pay attention to AQP going forward) and you don't always get a good setup or acceptable win/loss ratio and so move on.

Cheers


----------



## Wysiwyg (19 March 2011)

Reasons said:


> It is definitely about the size of the gap (but that gap size varies greatly depebding on the situation (I will pay attention to AQP going forward) and you don't always get a good setup or acceptable win/loss ratio and so move on.



Oh the price to fill gap with AQP is $5.79 not $5.60 as I previously wrongly posted. Must get my eyes checked. Thought it would be a good one to test going forward rather than doing the retrospective thing.


----------



## Reasons (19 March 2011)

tech/a said:


> These are *LAGGING* indicators.
> I dont use any lagging indicators at all in discretionary trading.
> To trade closing gaps you would expect a close or partial close in a few periods and you would be looking to go long on the retracement.
> Attempting to short a to a gap can work well with futs. Not that practical or successful with stocks.




Hi tech/a

I don't rate myself as good enough to be a discretionary trader and get in and out pretty much mechanically on strict rules, but I am pretty confident when using the MACD and RSI as leading indicators for my purposes.

I am too weather-worn to argue or try to convince you otherwise (and why should I if you have a system that works!). I have a mentor who swears black and blue about Stochastics that I can't get to work for me, but it helps make him money.

The rest of your response is answered above I think.

Cheers


----------



## tech/a (20 March 2011)

For gaps to continue I have found they need to be supported by Exhaustion or Demand in the extreme--shown in volume. You'll note that in this chart those that failed had immediately proceeding up bars closing higher.
Those that continue have low volume Down bars


----------



## Reasons (20 March 2011)

tech/a said:


> For gaps to continue I have found they need to be supported by Exhaustion or Demand in the extreme--shown in volume. You'll note that in this chart those that failed had immediately proceeding up bars closing higher.
> Those that continue have low volume Down bars




Hi tech/a

Assuming you are looking at daily charts, you are looking at much shorter gap timeframes than I will attempt. If I dropped down to 60/180/240/480 minute type charts I might have a chance, but it is not something I am paying any attention to at the present time. If I find big gaps like the CDU example above, that will generally arouse my interest as they can be tradable and have good risk-reward ratios. 

A hindsight example of *Wysiwyg's* AQP example is provided below. About the only gap I would have had a go at trading, had I seen it, is off the bottom at Point 2.

I like trading flat levels like support and resistance and that is simply because any 'blind Freddy' nuff trader or investor can easily see them and most will get set after I do and help my trade go in the direction I want it to. In an acronym, KISS.

For me the price action is king, any indicators are secondary and volume is optional (I mainly have it in place on charts so I can see the daily throughput so I don't get caught with a low liquidity share.)

My 2 main entries off a theoretical bottom or top into a share are a candle with a very small head and long tail (up or down) which shows strong rejection of a high or low price (and that is about the limit of my interest in candle patterns these days - KISS) or a minimum of 2 printed bars with a similar top or bottom price.

In hindsight I would only trade off Point 2 on AQP and ignore all other possibilities as I had no mechanical entry signal. Remember, I will not discretionary trade as I don't trust myself enough to do it. Mission control sets my trading plan and then I am just the pilot following the precise orders as issued.

From a flat level entry, there is excellent support at around $5.05 on several previous occassions and it acted as resistance as well, so my chances of it holding are good. The MACD at points 3/4 and RSI at points 5/6 are indicating some divergence up and support my position to enter long. The weekly timeframe is more convergent (sideways like the price action, but importantly is not diverging downwards and the monthly chart MACD and RSI are stongly moving upwards (convergent with the price action). Weekly and monthly chart not shown.

I would (and do) enter on the 3rd bar as close to the bottom of the previous 2 bars as I can (assuming it has not tanked below). Sometimes this means it is much higher on the 3rd bar open, but you get in as low as you can, but not chasing it where your risk/reward ratio is not acceptable.

The risk reward in these situations can be very good. 

1. Your exit is 1 cent below the previous low of the last 2 bars, in this case $5.09

2. The high of the day on the 3rd bar was $5.18, so lets say you got in there.

3. Your profit stop is $5.89

If you bought 2000 (~$10K) AQP with the above parameters you would have a profit/loss ratio of 7.89:1, or a potential profit of ~$1400 compared to a potential loss of ~$180. Good odds.

As this did not quite fill the gap in the first swing, I will leave it to your imagination if you took a lower amount and totally exited, sold half and waited to see if you could get a higher low and take more profits in the next swing, etc.

So in summary, if I was trading this gap I want the odds in my favour for the upswing:

1. Can even 'blind Freddy' easily see in the price action that the bottom has been reached in this case and they are about to miss out on the upswing?

2. Are my favorite indicators showing that there is divergence up or if nothing else are not diverging down on multiple timeframes?

3. Do I have an acceptable risk/reward (profit/loss) ratio?

4. Check the fundamentals and liquidity - is this about to ex-div or possibly deliver an annual/interim announcement? Do the fundamentalists think this is a good business? I subscribe to Stock Doctor to check the fundamentals - I want to think that these guys who don't read charts are also likely jumping on for the ride as well because it is a good 'value' propostion to them.

5. Document and execute the trade.

Unlike my CDU trade (previous post), there is no news theoretically driving this one up, just probability it will based on previous behaviour of this share filling gaps more often than not. If I am wrong, I have my plan in place and as the pilot, execute that plan to the cent as best I can.

I actually got into AQP a couple of days ago due to that rejection candle (nothing to do with gaps), but based on multiple hourly-type charts to test my flat level entry strategy using shorter timeframes with the MCD and RSI to back up my plan, but that is another story.

(BTW - I know why I don't join or participate in these forums very often, it takes up a lot of time to clearly respond so someone else can (hopefully) understand with some clarity how one trades!)

Cheeers


----------



## Reasons (20 March 2011)

And obviously that should have been SUPPORT LEVEL on the chart, not resistance.


----------



## tech/a (20 March 2011)

> Assuming you are looking at daily charts, you are looking at much shorter gap timeframes than I will attempt. If I dropped down to 60/180/240/480 minute type charts I might have a chance, but it is not something I am paying any attention to at the present time. If I find big gaps like the CDU example above, that will generally arouse my interest as they can be tradable and have good risk-reward ratios.




Gaps are made at openings they will be the same for whatever time frame you choose.
You only need recognize the gap  on open and you can only trade it with shorter timeframe charts if its a common gap and of course Futs.

I cant understand why your not trading gaps right now as conditions are perfect volatility at a peak. Gaps everywhere.


----------



## Reasons (20 March 2011)

tech/a said:


> Gaps are made at openings they will be the same for whatever time frame you choose.
> You only need recognize the gap  on open and you can only trade it with shorter timeframe charts if its a common gap and of course Futs.
> 
> I cant understand why your not trading gaps right now as conditions are perfect volatility at a peak. Gaps everywhere.




I only trade gaps opportunistically, usually with a setup timeframe before entry of a number of days like CDU. 

Gaps on opening are just not my thing as I (personally) would have no idea where the price action is going as I have done no research on them.

I can keep myself really busy in the main with trading flat levels, trends and counter trends which are really simple and boring and the more boring and simple the better I find.

I have only just started looking at shorter timeframes for shares on IG Markets advanced charting platform, which I have to say is significantly better and their data feed at least reliable compared to CMC.

Will need to concentrate on more price, pattern watching and backtesting on my boring mainstays first if AQP or its successors win/loss ratios tank.


----------



## tech/a (20 March 2011)

*Reasons *
Look into IB
Streets ahead as a trading platform and $6 each way brokerage.


----------



## Reasons (20 March 2011)

tech/a said:


> *Reasons *
> Look into IB
> Streets ahead as a trading platform and $6 each way brokerage.




Do you still have to have a US funded account?


----------



## tech/a (21 March 2011)

Reasons said:


> Do you still have to have a US funded account?




No Ive had an account for 4 yrs and I funded it with Aussie Dollars.
I trade Aussie stock and the DAX (euro) and the FTSE 100 Index (pound).
I dont do anything with the original funding its all taken care of by IB.
Their reporting is brilliant and a click of the mouse prints all for taxation.


----------



## Trav. (14 July 2020)

old thread but some interesting comments on gaps.

I like this site as he has done an incredible amount of testing and the numbers don't lie. A lot more info on the site if you are interested in this issue.

http://thepatternsite.com/gaps.html

_Gaps are useful for showing support or resistance zones but as a tradeable, by the time you properly identify them, the move is nearly over. If you already own a stock and a chart pattern breaks out in a gap, then hold on for a strong move. Performance improves two-thirds of the time in the chart patterns I looked at._​


----------

