DEFINITION of Gapping
Gapping is when a stock opens significantly above or below the previous day’s close with no trading activity in between. Partial gapping occurs when the opening price is higher or lower than the previous day’s close but within the previous day’s range. Full gapping occurs when the open is outside of the previous day’s range.
Gapping may also refer to a trading strategy in which the participant borrows short and lends long. This strategy gives the lender an overall better interest rate as short rates are usually lower than long rates.
BREAKING DOWN Gapping
Gapping is clearly visible on a price chart and interpreted as a trading opportunity due to increased volatility and interest in the stock. Typically, traders look for gaps that are at least 5% above or below the previous day’s close. Day traders either trade in the direction of the gap or fade the gap. In general, if the price goes up, it signals a buy, and if it goes down, a short. There are several variations of the gap strategy. Traders can use intraday and end-of-day stock market scanning software to find the best gapping candidates to trade.
Gapping and Stop Loss Orders
A trader can have a stop-loss order filled significantly below his or her stop-loss price (for a long position) due to gapping. For example, a trader may buy a stock on the close at $50 and place a stop-loss order at $45. The next day before the market opens, the company issues an unexpected profit warning, and the stock opens at $38. The trader’s stop-loss order now becomes a market order, because the stock’s price is below $45, and gets filled at the best available price; most likely close to $38. Traders can reduce gapping risk by not trading directly before company earnings and news announcements that are likely to have a material impact on a stock’s price. During periods of high volatility, reducing position size helps to minimize losses caused by gapping.
Gapping Trading Strategies
- Buying the Gap: Day traders often refer to this strategy as the "gap and go." A position could be taken on the day the stock gaps with a stop-loss order usually placed beneath the low of the gap bar. The gap should occur above a significant resistance level and trade on heavy volume to increase the chances of a profitable trade. Alternatively, traders could wait for prices to fill the gap and place a limit order to buy the stock at the previous day's close.
- Selling the Gap: Contrarians may use a fading strategy to exploit gapping. Traders could take a short position on the premise that most gaps close. A stop-loss order is placed above the gap bar’s high with a profit target set at the previous day’s close. To increase the probability of a successful trade, the high of the gap bar should be near overhead resistance, such as close to a moving average or a round number. (For more, see: Playing the Gap.)