Gap trading is one of the most poplar ways to day trade because there are countless different gap trading strategies and gaps offer great trading opportunities every day! One of the most popular ways to trade gaps is to look for and buy into what is known as a gap and go.
Rather learn by watching than reading? Check out my Gap & Go Trading Strategy video below!
Before getting into the gap and go trading strategy itself, I want to start from the basics and first explain what a gap in the stock market is. A gap is pretty much exactly what it sounds like. It's an empty space on a stock's chart caused by a lack of trading activity. This happens most commonly on a daily chart. The reason for this is because daily charts generally do not show price action during extended hours trading (pre market and after hours), so when a stock makes a large move to the upside during extended hours it is known as a gap up, and when a stock makes a large move down in extended hours it is known as a gap down. Companies generally will release news and press releases during extended hours, which is almost always the cause of any major gap in either direction.
Many traders don't like the thought of trading gaps because they believe the stock has already made its move during extended hours and by trading it after the market open they'd be too late. As someone that day trades full-time and focusses primarily on trading small cap gap plays, I can promise you that this is not true! Even though gaps have already made large moves, they still offer the best day trade opportunities because of the increased volume and volatility that they typically come with.
Realistically, the problem is that most new traders are not taught to trade gaps properly. Like I said, there are many different ways to trade gaps, both long and short. Each way of trading gaps will require different methods of analysis and entering/exiting the stock.
Regardless, the first step in any gap trading strategy is to... find gaps! Don't worry, I made this part easy for you because I share a Morning Watchlist every morning during pre market with the largest gaps, along with other important information such as the news headline that caused the gap, the number of shares outstanding, nearest support, and nearest resistance levels! However, if you'd like to learn how you can find these stocks on your own and create your own morning watchlist, you can learn how to do that here.
After you've found the biggest gaps for the morning, the next step is going to be to find which ones are most likely to gap and go. Since many stocks gap up and come straight back down, this part of the gap trading strategy is very important. After years of trading gaps myself, the criteria below is what I look for when determining which stocks are more likely to gap and go! Of course, like anything in the market, this isn't going to lead to a gap and go 100% of the time, but it should definitely keep you from buying into the worst performing gaps.
1. A Strong Catalyst: A catalyst like a piece of news released by a company is most likely to be cause of any major gap. The strength of that news often plays a big role in whether or not the stock is able to gap and go. Now, there's no exact measurement for how "strong" a catalyst is, but you definitely know that positive drug/treatment trial results is a much bigger deal than a minor product patent. It's also important to know what makes an earnings report strong because earnings are the cause of many gap, both up and down.
2. No Recent Dilution: Dilution can be a big red flag for potential buyers and investors. In its simplest form, it's essentially a large amount of added supply to the market. Unless there is some serious demand for the stock, all of that additional supply will likely drive the stock's price down and will make it much more difficult for the stock to gap and go. In my opinion, no matter what type of trading strategy you're using, you should always check a website like sec.gov or bamsec.com to see if the company has recent diluted or done any offerings. If you see a recent offering, that stock is likely to be a better opportunity to short-sell than buy.
3. Strong Chart History: History repeats itself! You can often look at a stock's long term chart (1 year to 3 year) to see how well it performed on other days that it has gapped up in the past. A stock that is in a long-term downtrend and regularly comes straight back down after a gap up is much less likely to gap and go than a stock that is in a long term uptrend and held held onto gains from past gap ups. Look for a bullish chart history for the highest probability of a gap and go.
4. Limited Nearby Resistance: If a stock has little (or even no) overhead resistance, it's going to be more likely to gap and go. Resistance levels are prices where a stock historically struggles to break above due to stronger supply (selling) than demand (buying). If there are multiple nearby levels of resistance, those prices can get in the way and prevent a stock from continuing to run after a gap up. While looking for nearby resistance, I primary analyze the 1 and 5 minute chart to look for any resistance that was formed during pre market on the day of the gap up, as well as the daily chart to find any major resistance levels from the past.
Those are the four main things that you want to se when analyzing gaps and looking for the next big gap and go. Again, these four filters are going to lead to a huge gap and go 100% of time, but they definitely won't lead you to buy into the worst performing gaps! I hope this post gives you some insight on how you can strategically trade gaps and profit from the gap and go strategy.
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