My Rules for Handling Gaps
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If you trade for a long enough period of time you will at some point encounter what is known as a gap. I define a gap as any price change that is a break between the prices of the previous chain of trading prices, enough so that on a chart the gap is apparent to the eye. Thus defining what is or is not a gap is a subjective decision on the part of the trader/technician.
Gaps cause a price break, whether they are on the upside or downside. While increased volume can cause a gap to occur, so can news that affects the value of the stock. In fact that type of gap can be caused with no volume. Such types of gaps are those caused by unexpected bad news like a poor earnings announcement, or maybe the company lost a big contract. As well, news-related gaps, as per the bullish type, can be that of a takeover announcement like the recent one in NYSE Euronext (NYX).
Whatever the case, I have a set of rules for reacting to gaps. Before listing the rules know that if you play the options game with negative gamma you will almost always be tested by gaps. In fact gaps probably cause the negative gamma players more financial and emotional headaches than do any other type of outliers that option traders encounter.
The rules are as follows:
1) Gaps will, enough of the time, eventually be filled.
2) When a gap appears to be setting up to violate rule #1, your bias should shift instantly to the direction of the gap.
3) It is best to wait, holding powder dry, as difficult at times as that can be, in order to give the retest potential time to set up.
4) The art of the trade is definitely in play when trying to determine both rule #2 and rule #3.
5) Positive gamma players love gaps.
6) Negative gamma players learn very quickly to hate gaps.
7) The upside/breakaway gap is almost always the start of a long in time and price bull move.
8) The downside/breakdown gap is almost never filled.
9) Daily charts, not intra-day charts, are far more efficacious when applying these gaps rules.
I am a positive gamma player. I hate negative gamma. Thus gaps are my friend!
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