Trading Options Using Gaps: A Comprehensive Strategy Guide
Gaps trading stands out as one of my preferred trading methods, yet also one of the more challenging strategies due to the risk of entering the wrong direction and facing immediate losses, which can be disheartening. Therefore, comprehending gaps, reasons behind their occurrence, and essential considerations when trading gaps are paramount. While numerous stocks experience gaps daily, not all are viable trade opportunities. Identifying the select few stocks that present favorable trading prospects is crucial in maintaining a balanced portfolio. Let's delve into understanding the dynamics of gaps, with forthcoming articles delving into practical approaches to trading gaps and leveraging Calls and Puts effectively.
1. What Are Gaps?
Gaps occur when a stock's opening price markedly differs from its prior closing price. A higher opening price than the previous closing price constitutes a gap up, while a lower opening price signifies a gap down. Alternatively, when a stock opens closely aligned with the prior close, or with minimal variation, it's considered a flat open.
1.2 Factors Contributing to Gaps
Various factors precipitate market or stock gaps, ranging from breaking news and earnings reports to analyst actions, economic indicators, and shifts in supply-demand dynamics. Gaps are often exacerbated by low-volume trading during off-market hours, amplifying buying or selling momentum beyond regular market activity.
1.3 Occurrence of Gaps
Gaps manifest across all trading days, with heightened occurrences typically observed on Mondays and Fridays. Larger gaps often present superior trade potential. Positive news catalysts, such as significant analyst upgrades or earnings surprises, tend to propel stocks higher, while unwarranted gaps may lead to corrective moves.
1.4 Exploring Gap Types
- Common Gaps: Sometimes referred to as a trading gap or an area gap, the common gap is usually uneventful. In fact, they can be caused by a stock going dividend when the trading volume is low. These gaps are common (get it?) and usually get filled fairly quickly. “Getting filled” means that the price action at a later time (few days to a few weeks) usually retraces at the least to the last day before the gap. This is also known as closing the gap or closing the window.
- Breakaway Gaps: Breakaway gaps are the exciting ones. They occur when the price action is breaking out of their trading range or congestion area. To understand gaps, one has to understand the nature of congestion areas in the market. A congestion area is just a price range in which the market has traded for some period of time, usually a few weeks or so. The area near the top of the congestion area is usually resistance when approached from below. Likewise, the area near the bottom of the congestion area is support when approached from above. To break out of these areas requires market enthusiasm and, either, many more buyers than sellers for upside breakouts or more sellers than buyers for downside breakouts.
Volume should pick up significantly, for not only the increased enthusiasm, but many are holding positions on the wrong side of the breakout and need to cover or sell them. It is better if the volume does not pick up until the gap occurs. This means that the new change in market direction has a chance of continuing. The point of breakout now becomes the new support (if an upside breakout) or resistance (if a downside breakout). Don’t fall into the trap of thinking this type of gap, if associated with good volume, will be filled soon. It might take a long time. Go with the fact that a new trend in the direction of the stock has taken place, and trade accordingly.
- Runaway Gaps: Runaway gaps are also called measuring gaps, and are best described as gaps that are caused by increased interest in the stock. For runaway gaps to the upside, it usually represents traders who did not get in during the initial move of the up trend and while waiting for a retracement in price, decided it was not going to happen. Increased buying interest happens all of a sudden, and the price gaps above the previous day’s close. This type of runaway gap represents an almost panic state in traders. Also, a good uptrend can have runaway gaps caused by significant news events that cause new interest in the stock.
- Exhaustion Gaps: Exhaustion gaps are those that happen near the end of a good up - or downtrend. They are many times the first signal of the end of that move. They are identified by high volume and large price difference between the previous day’s close and the new opening price. They can easily be mistaken for runaway gaps if one does not notice the exceptionally high volume. It is almost a state of panic if the gap appears during a long down move and pessimism has set in. Selling all positions to liquidate holdings in the market is not uncommon. Exhaustion gaps are quickly filled as prices reverse their trend. Likewise, if they happen during a bull move, some bullish euphoria overcomes trades, and buyers cannot get enough of that stock. The prices gap up with huge volume; then, there is great profit taking and the demand for the stock totally dries up. Prices drop, and a significant change in trend occurs. Exhaustion gaps are probably the easiest to trade and profit from.
In the forthcoming sections, we'll dive into actionable strategies for trading gap scenarios, both up and down, using Calls and Puts effectively to navigate market shifts decisively.