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Why Gap Trading Works and How to Profit From It

Apr. 08, 2011 12:51 PM ETUSO, NFLX
Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

 A common maxim in technical analysis is that a stock will always fill the gap. However, looking at this issue empirically, at what rate do gaps actually fill? Also why would this pattern continue to persist. The reason that gaps tend to fill is investor psychology of liking to see the price of a stock to be continuous and opportunistic short sellers to profit off of retail investors sudden jump into the stock.
 The general public will often get excited about a particular aspect of a stock such as a positive earnings report published after hours, a bullish change in a daily technical indicator, economic news that will help the security, an election, or any other piece of other sentiment driving news. As a result, they will buy the given security after hours so that the opening price the next trade is significantly higher than the previous close. Short sellers see this as an opportunity and the price will creep down a little bit. The same investors who bought into the gap creating hype will panic on the slight downturn and add to selling pressure. As a result, the gap will fill before professional investors either cover their shorts or buy back after the news hype goes away. Other possible factors that may drive gap fills include the self fulfilling nature of technical analysis or irrational exuberance.

  How can investors profit from the filling of these gaps is by either shorting these stocks directly or via options with put spreads (buy put at current price, sell at pre gap price). Using equity or options is depend on an individual investors risk capacity and familiarity with each type of security, but both will allow you to profit off the trade.

  An example of recent of a gap fill trade has been the price movement of Netflix (NFLX). A positive fourth quarter earnings report caused a gap jump in price from $183 to $210. The crowd momentum boosted the stock as high as $247. However, as soon as a slight change occurred in the trend, investors panicked and the stock filled back down to $183 before continuing its ascent. Other factors that made Netflix a good island target is that it featured overvalued financial measures and fundamentally is weakening from additional online streaming competition.

 The chart below shows a study done by finviz.com in 2008 to measure the probability of a upward gap being filled. As seen in the chart above approximately 90% of gaps of 15% or less will fill within 100 days. The average island gap up ranges between two and five percent, so the majority of gap trades will likely fill in the short term. Shorting gaps up seems to be a simple trade, but there are things to watch out for.

 Rules about how to maximize Gap trading effectiveness:

  • Gap trading tends to work only on the short with gaps up. Gaps down inspire fear that keeps the price down and fundamental factors such as bankruptcy, management changes, legal changes, FDA rulings (in healthcare), and other permanent changes to a companies economic situation can cause sharp gaps downward
  • Do not short islands based on mergers or buyout offers. Unless you have a strong fundamental reasons that you believe that the buyout will fail, the price of the stock will remain up near the takeover price
  • Put a limit cover order at the gap (for stocks) or sell a put (for options) at the pre gap price. This minimizes risk and gives you a set target return for a given trade. Gap filling can be a brief correction for a longer term bullish move in a stock.
  • For ADR's, currencies, and commodities, make sure the gap is not caused by price movements from international markets on a US Holiday. A notable example of this is the February 22 island caused by high amounts of oil trading (USO) done on President's day.
  • Gap trading works better if you have fundamentals on your side. Try to target weak or grossly overvalued securities when shorting based on islands. A strong company or hot name may take a very long time for the price to revert back to pre gap levels.
  • Watch for a slight breakdown in price before entering a short. Often times unwarranted optimism may cause a rally beyond the gap, so its best to wait once the stock moves slightly towards the fill.
  Overall, gap trading is an excellent strategy for short selling opportunities. Driven by investor psychology and aggressive short sellers, the island reversal has become a reliable opportunity for profitable mid term trading with a defined risk and reward. Since there is no database that keeps track of the best island opportunities, you must be discerning with your research. One way to make it easier is to check out my island reversal  and gap trading newsletter, that screens out all the top gap movements for the best opportunities and to avoid pitfalls mentioned in the rules above. I do not have the ability to trade every quality gap short, so I feel like I can share the information with other traders and investors. Try gap trading for yourself. Fundamentals seem to lag more on short side trades, so playing the gap may be a better alternative.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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