The Pitfalls of Those Morning Gaps

High-percentage gaps can exhaust further movement in that direction for an extended period of time. The reason is simple: The big move forces all uncommitted players off the sidelines, while winners take profits and losers take losses. This provokes an overextended condition that forces a reversal back toward the prior bar.

Opening gaps fascinate traders but require solid execution skills. Cash seeks opportunity at the start of the day while insiders paint the tape to encourage execution. This encourages a supply-demand imbalance, with ill-advised orders well above or below the market, depending on the gap direction. The resulting friction can set the stage for a reversal just minutes into the new session.

No easy formula shows traders how far a gap can travel and still remain healthy. But we need to apply common sense when observing premarket action above or below the last closing price. The most important question for traders to consider: Does the news and market environment justify the price you're seeing?

The level of crowd participation limits or fuels the strength and durability of the gap event. Certain gaps verify only when strong volume accompanies them. For example, a breakaway gap without heavy volume suggests it will eventually yield to a failed breakout.

The relationship between gaps and the crowd relies on complex interactions. For example, a high-volume gap may end movement in that direction because it uses up the last available supply for that trend. But another gap with less volume leaves just enough on the table to ensure sustained movement in that direction.

Old traders' wisdom tells us that gaps get filled. This classic expression does a good job describing the mechanics of retracement found in most trends. However, some gaps never fill. This suggests using common sense with these specialized patterns. Learn the unique characteristics of each gap type and then apply the strategy that aligns best with its behavior.

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Alan Farley is a professional trader and author of The Master Swing Trader. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. At the time of publication, Farley did not have any positions in any of the stocks mentioned in this article, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback and invites you to send it to [e-mail]. Also, click here to sign up for Farley's premium subscription product The Daily Swing Trade brought to you exclusively by TheStreet.com.

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