Gapping occurs when a stock, commodity, currency or other security sees a significant climb above, or decline below, the previous day’s closing price, during a period without any trading activity. This typically occurs after major news events that trigger sharp price movements, and is commonly referred to gapping up or gapping down.
After-market earnings releases, major company-related developments such as a bankruptcy or acquisition, and even market sentiment, can cause gapping from one day to the next, or over a weekend. The phenomenon occurs in both illiquid and liquid markets, and can also happen over shorter periods of time.
In the equity market, several trading strategies can be used to take advantage of these occurrences.
Investors can opt to trade in the direction of the gap, or “fade the gap,” which may entail shorting a stock (borrowing to immediately sell) in anticipation that a “gap up” will reverse course and the stock will decline. However, this fading strategy can be also be utilized when a stock is gapping down. In this scenario, a stock opens lower than its previous day’s closing price, and an investor buys the stock in anticipation that it will rise.
There are also different variations of gapping, including “partial” or “full.” Partial gapping is less volatile, as it happens when a security opens somewhere between the previous day’s high and low. Full gapping, meanwhile, involves a larger move, and occurs when a security opens above or below the previous day’s trading range.
Many financial news and data providers offer readers and investors lists of the biggest pre-market movers. This shows the top gapping up and gapping down stocks.
Traders should take note of factors such as the stock’s percentage move and price shift, which can help them eliminate undesirable trade possibilities, such as penny stocks for example.
Volume is another important factor for investors to watch, as low volume stocks likely offer less desirable opportunities to play the gap.
Using technical analysis and software that tracks equities provides a further edge to market participants who want to trade in the direction of the gap or fade the gap. Many highly sophisticated offerings such as these are provided by brokers at no addition charge.
Investors should also keep in mind that stop-loss orders (to buy or sell when a stock hits a certain price) don’t necessarily limit the downside exposure at a predetermined level. For example, if a trader buys a stock at the market close for $15 and puts in a stop-loss order at $10, if the stock gaps down and opens the next day at $8, that order will probably be filled somewhere around that lower level. This is because brokers are required to put trades through at the best price available, even though it may be below the trigger amount.
Guaranteed stop loss orders, which are offered by some brokers, eliminate this risk and guarantee that an order will be filled at the chosen selling price. However, since this amounts to purchasing insurance, brokers will implement additional charges.
As with any more complex form of investing, traders should consider all the risk management tools at their disposal.