Chapter 7-4 Gap Reversals
What is a gap reversal? A gap reversal is when the opening print of an equity security is substantially higher or lower than the previous day’s closing price. This is usually due to some extraordinary positive or negative news prior to the market’s opening. If this gap is a significant percentage of the stock’s price, trader sentiment could be looking to “fade” or reverse the stock. Basically, look to go long if the stock opens substantially down or look to go short if the stock opens substantially up.
These moves can be great trades. If there is significant size on the buy side of the limit book and very light order flow between the opening print price and the previous day’s closing price, then do not hesitate to reverse the position. Place a stop at an exit with some significant share size, technical significance, or at the opening price of the day. If the stock has opened at an overextended price up or down then trading activity will fade the gap created, thus producing you with significant profits.
There are certain ways to approach these moves in order to help prevent substantial losses and also to maximize your gains. Because of the potentially volatile nature of these moves, a trader must keep in mind that losses must be kept to a minimum. Do not “fade” or reverse every stock that gaps at the open. Set criteria that a gapped stock must meet in order to warrant execution. Remember, discipline is the key.
5 things to look for when entering a gap down on the long side:
- Overall market sentiment should be positive. The futures of the major indices must show some strength. This will help put traders in a mindset to go long. Moreover, if the stock is typically sector driven, such as a commodity stock, compare it to other stocks in its sector. Identify if strength throughout the sector exists.
- The gap down must be a significant percentage of the previous day’s close. Usually, anywhere from 2 percent to 5 percent are gap downs that have the best chance of reversing. Stocks that drop more than 5 percent on the opening print typically have less potential of reversing and are more risky.
- There must be bid support off the opening prints or soon after. Do not enter the trade if there is not an exit. If buyers are not aggressive then do not go long in hopes of them potentially getting aggressive. When looking to enter the stock, wait until it starts to move up. Look for large buyers who are coming in and taking out offers.
- After a large opening print, the offer side of the limit open book must be relatively thin and must look like the stock can run a minimum of at least 25 to 50 cents without much of a fight. There should not be significant size other than one or two small groups of sellers where you can get long from. This lack of resistance will cause sellers and shorts to second guess their positions should the stock begin to rise.
- Bids stepping up on the limit open book. This shows buyers are getting aggressive and are attempting to close the gap. This increases the probability of a reversal. Furthermore, look for size stepping up in price on the ECNs (such as ARCA and NASD). The stepping up or down of large limit orders on the NYSE limit book or ECNs typically provides valuable insight on the direction large traders are looking to drive the stock.
Vice versa when looking to reverse stocks that gap up on the opening print.