Wednesday, September 8, 2010

Traders Should Watch the Gap

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. We have coined this term to describe the current monetary and fiscal policies of the U.S. government, which involve unprecedented money printing. This is the official blog of the New York Investing meetup.

Anyone who rides a commuter rail in the United States is probably used to hearing a message to 'watch the gap'. The advice also holds for stock trading.

A gap is a price level on a chart where no trading took place from one time unit to the next time unit. This happens on daily charts when the opening price is above or below the previous closing price and the market continues to trade in the direction of the gap. Gaps in the stock market on the daily charts invariably show up on Nasdaq because all stocks open at a price determined by market conditions. Specialists try to balance the buys and sells on the NYSE and this can delay the opening of stocks there and smooth out the price. Since most Dow Industrial stocks trade on the NYSE and its stocks frequently open gradually over several minutes, gaps on the opening are rarely seen on the Dow. This also mutes the gaps on the S&P 500, which contains a significant number of NYSE stocks.

Markets move to fill gaps, or in other words trade at the price points that were missed when the gap was created. Most of the time, this happens anywhere from the next day to a few weeks later. It sometimes takes months or even years however to fill a gap. Short-term traders should be aware of all the gaps within the last few weeks on the indices, stocks, and even the ETFs they trade (even commodity ETFs fill their gaps on the U.S. charts even though these gaps are artificial because trading took place at the appropriate price points overnight). Traders with a longer term view should keep in mind gaps from the last couple of years that have remained unfilled.

Trading of U.S. stocks in the last six weeks can be viewed as an attempt to fill gaps. Nasdaq gapped up on August 1st and that gap was filled on August 6th. Nasdaq gapped down on August 12th and that gap still remains unfilled. Nasdaq gapped down again on August 24th and that gap was finally filled when Nasdaq gapped up on September 1st. The September 1st move however created a new gap. Nasdaq gapped up again on Friday, September 3rd and attempted to fill that gap in yesterday's trading, but didn't quite fall low enough to succeed. So Nasdaq has unfilled gaps both above and below where it is currently trading.

A market that gaps up and a down a lot is usually directionless, volatile, potentially unstable, and possibly manipulated. It can be a boon to short-term traders. It is not something however that a position trader or long-term investor should find attractive. Those with a longer view may wish to consider that Nasdaq has a large gap around 1800 that occurred in July 2009 and still remains unfilled.

Disclosure: No positions.

Daryl Montgomery
Organizer, New York Investing meetup

This posting is editorial opinion. There is no intention to endorse the purchase or sale of any security.

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