Stocks seldom open at the same level at which they closed in the previous session. When they open well above the previous session’s high or below the previous session’s low, they form a ‘gap’ in the chart. The Japanese, in their picturesque terminology, called these ‘windows’. Analysing these gaps or windows provides an analyst with vital clues regarding the trend in the stock.
While an analyst would welcome gaps in the charts, position traders would be happy to issue a ban on gaps, if they could. They play havoc with positions that are rolled over as stops become redundant in a large gap opening. The only recourse when stuck on the wrong side of a gap would be to book the loss and exit.
What can an intra day trader do if the market opens with a gap in the morning? He would need to take in to account the prevalent trend in the morning before acting on a gap. For instance, if the market is in a strong up trend, it can stabilise at the higher level after a gap ‘up’ opening and then move up further in the later half of the session. So, the trader would wait for the prices to sustain at higher levels for at least an hour and then play long with a stop just below the level where the gap began.
Similarly, in a market that is trending down, downward gaps would be common. If the price moves sideways after a downward gap, there is a high degree of probability that the price would fall further as the trading day advances and hence provides an opportunity to go short for the intra-day trader.
It is, of course, of paramount importance to determine if the gap is a strong one that will go unchallenged for many days or a weak one that will get filled the same day. The magnitude of the gap would play a critical role in deciding its strength. As a rule of thumb, smaller gaps are more likely to get filled the same day when compared with a larger gap.
The way to determine if the gap is small or large would be to compare with the previous day’s trading range. Gaps that are more than 50 per cent of the previous day’s trading range are more likely to remain open for a while when compared to gaps that are less than 50 per cent of the previous day’s trading range