The first step to becoming a price gap trader is to understand what a gap is. Here’s what you will learn in this section:

1. What is a gap?

2. Why do gaps occur?

3. What is the real meaning of a gap?

4. How to find gaps.

5. Exercise: Find a good gap to play NOW

What Is a Gap?

Technical analysts, such as the future you, disagree on the definition of a gap. Though they agree that a gap is simply an empty space (meaning no trades on those values occurred) on a candlestick chart, some say that a gap is when a space appears between the two day’s candlestick bodies. Other say that a gap is only a gap if the space is between the entire candlesticks, shadows and all. See the following figure to get an idea.

 

No matter which definition you prefer, the gap is a highly profitable phenomenon in the stock market. For the rest of this book, we will define a gap as a space between the bodies of two candlesticks; this definition is all-encompassing and allows us to talk about both gap definitions in the same language. The truth is, you can profit the same way on either type of gap by taking advantage of its sudden directional movement and some particularities of the trends following a gap.

Now that we’ve defined a gap via a candlestick chart, it’s time to pry into what a gap really is. First, understand that gaps can occur above or below the previous day’s candlestick. The former is called an up gap – when a stock opens and closes higher than the previous day’s close. The latter is called a down gap – when a stock opens and closes lower than the previous day’s close. The following figures show the difference.

 

 

Though we just defined what gaps are, let’s quickly pry into their real meaning. When an up gap occurs, the traded stock suddenly realized a gain in price that continued upward till the end of the day. Visa-versa for the down gap. Note that this is uncommon in the world of stocks; most stocks that open higher than the previous day’s close are naturally traded off at high levels at some point in the day, causing a decline in price. Thus a gap indicates a general consensus among traders that the stock is undervalued (up gap) or overvalued (down gap). Because of this, a buying (up gap) or selling (down gaps) pattern begins. The severity of this pattern determines the size of the gap.

Naturally, a gap tends to come as a result of some news related to the stock. News ranging from scientific breakthroughs to industry declines can all cause gaps in certain companies’ stock. I could give you a whole list of news events that are likely to create gaps, but such a list wouldn’t be helpful. Remember the key theory for profiting from technical analysis: All of the information you need is in the price of the stock and therefore on the candlestick chart. We will ignore the news and focus on trading gaps with a statistically-sound strategy. 

Tip: Ignore news; let the candlestick chart guide you.

That said, once you start seeing gaps in candlestick charts, you’ll become curious as to what caused the gap. To satisfy your curiosity, you might shift to searching for news on the stock. I believe this is just a waste of time – it’s easy to get distracted and find yourself suddenly in a news-reading marathon. In addition, news can sometimes cause you to second-guess yourself. But if you can read the news, scratching your curiosity itch without creating doubt in your technical analysis, by all means go ahead.

Second, know that not all gaps are created equal. Technical analysts have categorized gaps into several types, which we will investigate later. For now know that your first action after spotting a gap is to determine what kind of gap it is. This is crucial in predicting the following movement of the stock.

Tip: While candlestick patterns are mostly cut-and-dry, gap types are somewhat subjective, making gaps harder to categorize than candlestick patterns.

Third, the profitability of gap trading comes from predicting the correct direction. Unlike some options-trading strategies, such as time spreads or credit spreads, most gap-trading strategies actually require the stock to move for you to profit. Luckily, movement after a gap tends to be highly likely as most traders are scrambling to “get in on the trend” or “get out while they can.”

When we talk about the direction of the stock after the gap, we tend to use the phrases “the gap widens” and “the gap fills” to represent further movement away from the gap and a reversal of movement (movement toward and into the gap), respectively. The key to trading gaps is to accurately predict whether the stock will move in the direction of the gap or fill the gap.

Why Do Gaps Occur?

Intuitively, a gap between December 8th and December 9th should mean more than does a smooth transition between the stock prices on those dates. Indeed, when you see a gap between two consecutive days’ prices, you should expect that something happened – in most cases. 

When you become a gap trader, you’ll find gaps appear for one of four reasons:

Random Market Fluctuations

Let’s start with the most boring and uninteresting case: random chance.

Some gaps occur simply because of natural market fluctuations. These gaps are usually small and don’t offer much in the way of making large profits. These gaps, called area gaps, are consistently filled, which allows gap traders to consistently make small profits from these gaps.

However, though a gap caused by random market fluctuations is always an area gap, as you’ll find out later, not all area gaps are caused by random market fluctuations.

The majority of gaps caused by random market fluctuations are filled by the end of the day. Those that remain open are filled within the following days. You can only profit on these gaps if you act fast, opening your position before the gap closes and exiting your position as soon as the gap closes.

The News

News reports, ranging from rumors of mergers, experts’ opinions on the stock-in-question, and even who the CEO was found in a hotel with last night can have a significant effect on the price of a stock. 

While some gaps caused by news are area gaps, or small gaps that close quickly, many are not, resulting in wide, trend-breaking gaps. These tend to be the most profitable of gap types, at least in terms of play-by-play, because they cause price of the stock to move violently in one direction. Post-movement, the stock price tends either rebound or continue up.

A gap caused by news is perhaps the easiest to understand, as the image of the stock in the investors’ eyes is significantly changed by new information. The most important aspect of the news isn’t the news itself but how investors receive it. Interpreting the direction a stock will move based on the news is usually easy: Good news boosts the price; bad news makes the price drop. However, the more important aspect for people like us, people who play the stock market, is whether the investors are overreacting or underreacting to the news.

If investors are overreacting to the news, we can expect a reversal of the price movement, which can either close the gap or partially close the gap. In this case, we can profit by betting in the direction of filling the gap. Likewise, if the investors are underreacting to the news, we can assume the stock will continue to move in its current direction, allowing us to profit from getting in on the trend early.

Dividend Payouts

When a dividend stock pays out its shareholders, you will often see an immediate drop in the price of stock. If this drop is large enough, a gap will form.

What is happening is that investors are taking their dividend and selling off the stock as soon as they fill their greedy little pockets with that dividend income. Though the dividend has been paid out, the company’s fundamentals have not changed. Therefore, the price of the stock should, theoretically, not drop.

The market corrects this problem. The drop in the stock price soon corrects itself. In other words, if we see a gap due to dividend payouts, we can be confident that the gap will fill soon. This presents another profitable opportunity: buying the stock after the dividend payout and selling it when it regains its pre-dividend price.

Unfortunately, these dividend gaps tend to be small – about the same size as the dividend itself. Thus, playing dividend gaps cannot bring in large profits unless played consistently or in high volume (to outweigh commissions).

Dividend Deadlines

Though I’ve never seen this gap mentioned in the literature on gaps, I’ve seen this type of gap many, many times in my own trading experience.

Let me explain this via example. A dividend deadline works like this: Company XYZ will pay its shareholders dividends on August 13th. In that case, why not just buy the stock on August 12th, grab the dividend on the 13th and immediately sell it off? Genius idea, right? I agree. And so does the stock market, which is why you cannot do it.

Companies only give dividends to shareholders who bought stock before a certain date. For Company XYZ, for example, that date might be June 1st. If you haven’t bought stock by June 1st, you don’t get the dividend.

What follows is a rush of people to buy stock in XYZ by June 1st, sometimes causing a spike in the price. This can cause a gap. Naturally, this stock price will correct itself by the next day, June 2nd, at which the gap is filled.

Or, sometimes as I have seen, it is the deadline of the dividend that makes the gap. After June 1st, Company XYZ’s stock technically offers no dividend, making it less desirable. Therefore, investors devalue the price of the stock, which causes a drop in price, thereby causing a gap.

In either case, the gap tends to be small and is quickly filled. Just as with dividend gaps, you can profit on these gaps through consistent, high-volume trading. Though area gaps and gaps caused by news tend to be much more profitable for serious gap-trading.

The Real Meaning of a Gap

Understanding the real meaning behind gaps is not necessary for trading gaps. However, it does give you an insight into knowing how the market works. I recommend you read this if you are serious about trading gaps, as it will go a long ways into forming a systematic decision-making strategy for playing gaps, regardless of the individual tactics you learn from me.

So what do I mean by the “real meaning” of a gap? Aren’t gaps just caused by news and random market fluctuations? Yes and no.

Yes, gaps follow the news. But they follow the news because the news imparts novel information upon the investor, who then sets a subjective value for the stock, which mixes in with other investors’ subjective values for the stock, which then compete and converge to a single price. (Try reading that sentence in a single breath.)

Here’s an example to make things easier:

1. Stock X is trading at $32.

2. A income report from Company X hits the news. It states that Company X failed, by a large margin, to meet its yearly income predictions.

3. Investors scramble to predict the new fair price of the stock.

4. The majority of investors overreact, selling the stock at increasingly lower prices, sending the stock to $26.

5. Other investors see this as an overreaction, and buy up the stock at $26, $27, and $28.

6. Some of the investors who bought the stock at $26 see this new buying phase as an overreaction to the initial overreaction to the news, and sell the stock at $28.

7. This process repeats until a new, stable price is found (assuming no new information about the company comes out).

This is an example of a breakaway gap that partially fills.

Now, you don’t need to understand this entire process to understand gaps at a fundamental, theoretical level. Once you remove people from the equation, understanding gaps becomes much easier:

1. The market sets the theoretical fair price of a stock.

2. New information (e.g., news) sets the new theoretical fair price of the stock.

3. Investors either overreact to the new information, underreact, or correctly guess the correct fair price (a rare occurrence).

4. The market corrects the overreaction or under-reaction over time.

5. The stock price stabilizes at the correct stock price.

 

We might find gaps both at steps 2 and 4, depending on how fast the market is to respond to the new price.

In fact, the entire explanation above can be used to discuss all aspects of market prices – not just gaps. Essentially, each stock in the market has a theoretically fair price. All the investors are attempting to guess that price based on incomplete information. Eventually, the price converges around the theoretical price, with random fluctuations due to information asymmetry among the investors and due to investors entering and exiting the market.

If you were to know the true theoretical fair price of the stock, you would always know the direction in which to bet. But knowing that price is impossible. Even if we were to collect all the possible information to estimate that price, we will be subject to failure because of:

• new information arriving too quickly

• human error

• psychological bias (e.g., halo effect of a likeable company)

Thus, we can only rely on a limited set of information that will rarely be good enough to make profitable predictions.

This leads us to what we are doing now: learning how to trade gaps based on statistically sound trading strategies. Although we will never know the true price of stock XYZ at time t, we can at least correctly guess whether the price of stock is overvalued or undervalued most of the time.

It is in our guessing correctly most of the time that allows us to make a profit. Over a long enough time frame, with predictions that are correct the majority of the time (70% or over), we can reap in huge profits from buying, shorting, and playing options on price gaps.

How to Find Gaps

The title of this section should actually be how to find playable gaps. But to find playable gaps, we first have to find gaps in general.

First recognize gaps as either one of the two:

1. An opportunity to make a quick and certain, but small profit (area gaps, dividend gaps, dividend deadline gaps, and amateur gaps)

2. An opportunity to make a slow and uncertain (~70% probability), but large profit (breakaway gaps, continuation gaps, and professional gaps)

As you can see by the types of gaps available to trade upon, these two simple opportunities stem from a wide range of phenomena. And trading gaps requires you to understand each of these phenomena not because you want to profit from each type of gap but because you don’t want to confuse types of gaps – doing so could cost you a lot of money.

Thus, trading gaps at a high level requires the following:

1. An understanding of what a gap is.

2. The ability to determine gap type.

3. The ability to determine the trend following the gap.

4. The ability to develop/follow a stock/options strategy for profiting on gaps.

Supplementary knowledge that can help you maximize profits includes:

1. Understanding why gaps form.

2. Knowing how to determine whether a stock is underpriced or overpriced.

3. Knowing the statistical trends that apply to most stock.

This guide on trading gaps will certainly teach you the first four techniques. (I hope you will also learn a good deal of the other three techniques from my newsletter.)

Of course, if you want to profit from gaps without all this learning, you could just read and follow along with the individual gap-trading plays in my newsletter. But I hope you’re interested in learning for yourself, as well, which is why you are reading this guide now.

How to Locate a Stock with a Gap

This can be hard or easy, depending on your resources. I use software that picks out stocks that have gaps in them from the past few days. Sometimes, I’ll shift through a collection of random stock to find a gap.

I’m going to make this easy for you and advise you to either perform a Google search on price gaps in whatever market you’re interested in or use the links I provide below. 

If you are searching for gaps on your own, know that gaps are not rare. Don’t sweat this step.

List of daily gaps:

Gaps down

Gaps up

The above two links will give you all the gaps from the previous trading day. Bookmark these links unless you already have software that can locate gaps for you. You might also want to take daily screenshots of these two links so that you can have an archive of gaps. 

It’s not always a great idea to trade a gap the day after the gap. I usually play gaps 2 or 3 days after the gap occurred, simply because I’ll have more information on what the stock price will do post-gap, making my trades more successful.

How to Determine whether a Gap Is Playable

Not all gaps are playable. I’ll give you a few reasons why:

1. Some stock prices are too low to be profitable.

2. Some stocks have too little volatility to make a significant move after a gap.

3. If you’re an options trader, not all price gaps occur on stock with options.

We must therefore filter out the unplayable gaps from the playable. I will show you what to look for by showing you what NOT to look for:

Don’t play gaps with tiny volatilities.

Don’t play gaps with tiny volumes.

Don’t play insignificantly small gaps.

Anything else is good to play! 

I’ll give you my personal gap-finding strategy:

1. Find the gap with the largest volume.

2. Look at the volatility. 

3. Look at the size of the gap. 

If (2) shows that the previous trend was anything but flat and (3) shows that the size of the gap was at least $1, I’ll play. If not, I’ll go back to step 1, finding the gap with the second-largest volume.

Exercise: Find a playable gap NOW

Objective: Find a gap that we deem “playable.”

Estimated Completion Time: 10 minutes

After having read this chapter, you know exactly what to look for when searching for price gaps. Now, it’s time to find such a gap. This is the first step in actually trading gaps.

Recall the three questions you must ask yourself when looking at gaps:

1. Is the volume large?

2. Is the volatility large (e.g., was the previous trend anything but flat)?

3. Is the gap profitable (e.g., is the size at least $1)?

Always ask these questions before you apply the techniques you’ll learn in the coming chapters. If you answer “no” to any of the above three questions, drop the gap. Don’t even consider playing a gap that doesn’t meet the above criteria, as you’ll be more likely to lose money than make it.

Now apply these questions to the gap list you’re looking at (links appear below if you don’t have any price-gap resources):

Gaps down

Gaps up

Exercise:

1. Open a list of gaps.

2. Cross out any with a low volume (volume < 1 million).

3. Cross out the remaining gaps that have a previous flat trend.

4. Cross out the remaining gaps that are not at least $1 wide.

What you’re left with is a list of playable gaps.

Sometimes your list will be empty. It just means that no playable gaps occurred on that day. This is a rare event, but it does happen. In the real world, you have two choices: wait until tomorrow to play or play a gap from one day to four days before.

A wise gap-trader knows that it’s better to wait for the right gap. Be discriminant with your gaps, and you’ll set yourself up for success over the long-term.

You’ve just completed step 1 in the Gap Gameplan. Let’s get ready to make some money. In the next lesson, you will learn how to analyze gaps, which means you’ll be able to correctly predict the direction a stock price will take after the gap, most of the time.

In fact, you could use just steps 1 and 2 from this course and be a moderately successful price gap trader. However, I hope you’ll finish the course before acting on what’s coming up next.