Beginning traders were probably shocked the first time they experienced a stock price gap. I guess even the most experienced traders still get taken back when there is an unexpected stock price gap in a stock they are trading. Either way I wanted to cover once again why they happen and what you can do (if anything) to trade them.
It Happens When The Market Is Closed
Nearly all stock price gaps happen in pre market trading or during after hours trading. Call them Black Swans if you want since they seemingly come when you least expect it.
Generally speaking gaps are rare for the normal stock. Most mutual funds, ETF’s, and other illiquid assets actually gap more frequently which make the gaps less important.
How The Actual Price Gap Is Created
A price gap is created when a stock closes at say $91.50 (as AAPL did below) for the day which is at 4:00 PM EST and then the next day opens dramatically higher or lower than it’s previous closing price of $91.50.
In after hours that same day or pre market trading the following morning, something newsworthy happens to create either a buying or selling frenzy. The result is a gap in the stock price when the market re-opens at 9:30 AM EST.
The most common reasons price gaps occur is because of earnings and acquisitions. The bigger the stock price gap, the more important or influential the reasoning behind it. Any major event that dramatically changes the value of a stock today (or it’s future business value) will immediately effect the stock price when the market opens.
Let’s Look At A Real Life Example
Using Netflix, Inc. (NFLX) as our classic example, you can visually see that the trading creates a gap in the daily candlesticks. What happened in this example to create the gap in NFLX stock?
Well, the stock closed on 1/27/10 at $50.97, then reported earnings after the market closed which were much better than the analysts on Wall Street had expected. In after hours trading, NFLX stock traded higher to $63 on the earning excitement.
The next morning when the market opened it created the classic gap in the daily stock price of nearly 26%. This left this huge visual gap on the chart.
Do Price Gaps Help Predict Future Moves?
While the actual gaps themselves are virtually unpredicable – stock price gaps are fairly good at predicitng the future price of a stock following the gap. Of course we would all like to know when a stock is going to gap higher so that we can buy it right? But it’s what happens after the gap that acutally can be very useful for you as a trader.
A price gap up or down in price can actually be a determination of the overall direction the stock will move in the coming months. For the most part volume is the big indicator and confirmation sign during a price gap.
A stock price gap on very high volume like the one below means that strong institutional buying of the stock could send prices higher in the weeks and months to come.
Like I said before, the size of the gap is also very important. Smaller gaps are less important and actually can happen on daily basis for some stocks. But it’s the large and obnaxious gaps that kind of jump off the screen that you should pay attention to when trading.
Gaping Support/Resistance Levels
Personally I like gaps for the technical importance they serve in determining strong areas of support and resistance. With stock prices gaps the whole area of the “gaping window” as it’s called can act as strong support and/or resistance going forward.
In the examples below, you can see that the gaping window successfully acted as S/R levels for these stocks following the initial gap. More experienced traders will look for an entry following a pull back in the stock that is much more favorable.