In the previous article we discussed what are gaps, what causes gaps, when gaps occur and types of gaps. In this article I will tell you my four different strategies of trading gaps.
1.4 How I Trade Gaps
Ideally when a stock gaps up, we should not buy “Calls” unless it makes a new high after 10:00 AM EST. Similarly, if a stock gaps down, we should not buy “Puts” unless it makes a new low after 10:00 AM EST. When stock gaps up it makes a high and then reverses to the downside but stays above the open price. It trades aggressively between open price and high price. Professionals try to short at high made during the first thirty minutes of the market open. They place the stop just little above the high which was made during the first thirty minutes. At this stage the battle rages between the bulls and the bears where bears try to push it down and bulls buy on every dip and eventually one of them wins.
1.4.1 How I Trade Gap Up – By Buying Calls
I watch the five-minute charts and see how stock is trading. Usually it oscillates between open and high. I also watch buy and sell pressure to figure it out which side will likely win. Sometimes it is evident from the get-go who will win sometimes it is not clear till later stage. To enter long the ideal entry is when stock pulls back and comes closer to the open price but do not violate it. As soon as the stock comes close to open price and buying pressure starts building up that’s when we could go long with the stop either just below the open or below the support price which is below the open price. This is low risk high reward trade and decision has to be made quickly and trade executed at lightning speed. If the amount of gap is significantly high then the profit target could be just below the high made so far. Another entry for going long is when stock breaks the high made during the first 30 minutes. The stop in this case is below the open price of that day or the low made so far. If there is a support level below the open then the stop is below this support rather than below open. Usually the stock dips below the open to take out the stop and then it moves upward very fast.
When I am buying calls then I buy only half lot and keep another lot to buy either at lower price (near open) or buy second lot when it breaks the high made (within 30 minutes) decisively and moves aggressively upward.
1.4.2 How I Trade Gap Up – By Buying Puts
When the stock gaps up on news then analyzing this news is very important. Before the market opens reading the news on the stocks which are gapping up is crucial to understanding what the stock would eventually do after the stock starts trading during normal market hours. If the stock is gapping up for no good reason, that is no substantial news to justify the gap, then it is likely a good candidate for fading the gap. In other words if the gap is overly exaggerated the stock will likely reverse its direction to the downside and if the gap amount is significant then a trader can buy Puts to take advantage of the reversal. Another factor which helps in my decision whether to fade the gap or trade in the direction of the gap is where the stock is trading at open with respect to the resistance. If the stock gaps up and hit the resistance and unable to conquer the resistance right at the beginning then it has very high chance that it will fail to cross the resistance later during the day and rather it will sell off. If this is the case then a trader can buy Puts with stop 50 to 70 cents above the resistance line and lock gains when stock approaches the support. The potential between resistance and support should be enough to justify buying Puts as option trading requires certain dollar amount move to justify the spread between bid and ask.
1.4.3 How I Trade Gap Down – By Buying Puts
Gap down strategy is the same as gap up but in reverse. Stocks gap down due to some major bad news. When stock gaps down a trader needs to evaluate the further potential in the trade, buy/sell pressure, any major support nearby which could stop further decline in the stock move. For example, if stock gaps down and 200 day moving average is close by then it has high probability that it will stop going down further once it hits 200 day moving average. Even if it dips below 200 day moving average it could bounce back above.
If the stock has gap down huge and there is no significant support nearby and selling pressure is rising then the chances are that it will continue going down in the direction of the gap. During the first 30 minutes of market open – day traders try to fade the gap by going long and placing the stop just below the low made during the 30 minutes. Once this low is broken then the selling pressure starts rising and they switch their position from long to short. It is at this moment or knowing that stock is further deteriorating that a trader can buy Put with a stop above the high made so far. However, if the gap is huge this high could be far from the entry point and if stock reverses to the upside then trader can lose significant portion of its trading amount by the time he stops out. Therefore, I look for another resistance point which is way below the open or high and if stock closes above this resistance line then I close my Puts position otherwise the profit target is slightly above the next major support. Since gap down trading can be fast and furious and stock could reverse its direction after hitting the support therefore, I do not take risk of greed factor to come into play. I place conditional order (described later in this guide book) and let the price move take me out of the trade with profit. In this way greed factor is eliminated and I am out of the trade with decent profit. Knowing the resistance, support is the key to trading gap down trades.
1.4.4 How I Trade Gap Down – By Buying Calls
When stock gaps down and hit support it stops going down further. Not only it stops going down but starts moving up aggressively. Recognizing this change in trend a trader can buy Calls with stop below the low made during the first 30 minutes. The profit target is the first major resistance. The move could be fast therefore, I prefer to place conditional order and let the trade close itself with profit. The conditional order eliminates the greed factor.
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