The Contrarian Trader:  Playing The Gap

One profitable way of trading stocks that has proven its worth over the years is playing the gap. You’ll no doubt find many posters on this site will offer this stock trading variation on certain stocks that closely follow this pattern.

A gap occurs when the opening price of a stock is substantially higher or lower than the previous day’s closing price, usually because of some intervening news—positive or negative.

Of course, if the stock “gaps up” and you’re holding long, then hurray! You’ve made a tidy profit. But if you’re holding long and the stock craters at the open, then, well, that’s the price of holding any stock overnight, whether you’re a day trader or an investor.

The “gap” is easily represented on the charts with a large open space (yeah, that’s right, a gap) between the close and the next day’s open.

Playing the gap is merely a contrarian trading strategy that suggests you can make money when you trade in the opposite direction of the gap. For example, if MSTR gaps up $3 at the open, you’ll likely see such a stock continue to rise briefly during the first half-hour of the market. But after 20 minutes or so of trading, it will begin to fade. And it’s that probable fade that the short trader will jump on.

The same is true of stocks gapping in the other direction. If a stock opens the day substantially down, some traders will wait for the bottom to appear (in other words, catch the falling knife) and go long and hold until it shows a decent profit.

But a proviso is in order. Stocks that gap up don’t always fade any more than stocks that gap down recover their lost territory on the upswing. The key is timing and that all-important sell stop or buy stop. If a drug maker announces overnight its discovery of a cure for cancer, you can bet its shares will gap up big-time in the morning. But the price might well keep on going. Pay attention. Keep a short leash on stocks that gap in either direction.