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Trading Class 101: Understanding Gaps - A Very Important Lesson

May 26, 2008 12:20 PM

redarrowup.jpgexitdown.jpgProbably the most difficult thing in trading to understand is “gaps”. When the market or a stock makes a huge gap move from the previous day, where is the trade? If a stock gaps lower, should you sell and get out or buy more? This is not as simple as it may seem at first glance. The answer is - it depends on the reaction to the gap.

Let’s glance at GE on the huge gap lower on 04/11/2008. The closing finish that day was weak relative to the open. What does that suggest? It was extemely likely it was going lower. How low? I had no idea that day, but I knew the gap was not to be bought and was almost certainly going lower than $31.81 (and it did). What if GE had closed that day at $33.05 instead of $32.05? Then the trade was likely long once $33.05 cleared and the gap was likely to “fill”.

Now let’s look at a gap to the upside. BMC recently gaped higher on 05/16. What was the reaction that day? Was there a resounding rejection in price? No. Therefore, the trade is stay long. The only reason BMC has not moved significantly higher since is the market has plunged. Otherwise, it would be far higher. Period.

Also, look at the 04/18 gap higher on GOOG. Was the gap higher bought, or was it sold? it was very clearly bought. What is the likely direction for the stock? Higher. If you were short that stock prior to earnings (gambling) there, you would be in HUGE trouble and you would have to cover it.

You could easily spend $25,000 in a trading course and not get this seemingly small piece of information of which I have just given to you for free. That may sound like a very bold statement, but it is a fact. Watch the gaps, watch the reaction to the gap, and you will gain an understanding of where it is headed.

This is important whether trading or long term investing as you HAVE to know if you are in trouble on a stock, or not. Big gaps do not always mean what people assume. It depends on the “reaction”.

Written by Tom@StockBlade.com · Filed Under BMC, GE 

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