The Evaluation of Trading Gaps

Definition

A trading gap is simply price movement when the market is closed, outside the trading range of the previous day.

When does normal trading cease?

Normally all trades are completed 20 minutes after the acceptance of new bids for execution that day has been terminated. In that period existing accepted bids which can be matched out in an auction process are completed. In a similar way a 20 minute auction period prior to the open allows for a corresponding settlement process.

I understand that some trades do transpire outside these hours when there is price consensus between buyer and seller.

How and why do prices alter?

Some shares trade on international stock exchanges, allowing for continuing price fluctuation.

Prior to the open, traders have the opportunity to change their bid and sell prices on the exchange’s market depth listing to take into account any alteration in trading conditions or market sentiment, thus influencing the opening price.   Examples of this might be:

  • Shares going ex-dividend.
  • Adjustments to take into account the movements of international indices, particularly those in the USA.
  • Profit and loss statements and other continuous disclosure announcements by the company out of trading hours.
  • Analyst reports.
  • The appearance of large known buy and sell orders.
  • Market management by large institutions to improve their trading liquidity.
  • Trading to target known stop/loss positions triggering losses for those who have misdiagnosed the direction of price movement.
  • Changes in company market rating.
  • Trading rumours.

The Significance of gapping.

Price gapping over-night can be disastrous for traders particularly for those using leverage, when the movement is against their position. For this reason most short term traders are day traders only and close out their positions before the market closes.

Measurements of the true range for the trading period include the gapping range, and are therefore a more accurate indicator of price momentum than the intraday trading range.

Large range days send a powerful signal to the market. Early in the evolution of a trend, they usually signify the most favourable direction in which to trade; these gaps are then referred to as “breakout” or later in the trend as “continuation” gaps, When they come after a period of extended trending, they are likely to be so called “exhaustion gaps” and the favoured direction to trade may well be a contrarian one.

The Opening Gap

This is the gapping that traders fear most. It is the gap between the closing price of the previous day, and the open price of the day in question when the trader is faced with a significant loss on one’s position, having had no opportunity to close out the position earlier to minimize the loss.

The common belief that gaps will be closed by subsequent trading cannot be relied upon. Gaps frequently become new support and resistance levels. If it is a rising gap, short positions have to be closed out promptly whatever the loss; in a falling gap it is long positions that must be dealt with.

Don’t fight the gap

One might consider the current share price to be over-bought or over-sold, but it is never wise to try and trade contrary to the direction of a gapping trend.

Some traders consider that after three gaps in one direction, the trend is likely to change. It is better, I have learned to my own cost, to not pre-empt market turns, but to wait until the new trend emerges. Stay out of the market until then.

Taking a short position even in what seems to be an obviously over-heated market is all too likely to end up with one becoming a forced buyer at an even more inflated price, when one’s stop/loss position is targeted.



Categories: Trading opinion

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