Day Trading Price Gaps: Rules And Strategy

‘Mind the gap’ is the warning announced at all London Underground platforms as a tube train arrives or departs from a station. It refers to the gap between the platform and the train, and is broadcast loudly and incessantly. It is an essential part of the sound of the city.

A different sort of gap occurs on the stock market, but a ‘Mind the gap’ warning is not broadcast to traders. On the stock market we use the term ‘gap’ when referring to a situation where a share price opens at a different price to the closing price of the previous day. Some new investors and traders naively think that a share price opens every day at the same level it closed at on the previous day, and then proceeds to move up or down. That is most certainly not so. A share can open at any price at the start of trading.

Price Gap Example

Let’s take for example a fictional company which I shall call ‘Shakey Enterprises’. The shares close at £2.50 on Monday. On Tuesday morning, before the market opens at 8am, Shakey Enterprises announce a profit warning stating that profits will be 20% below forecasts. At 8am, Shakey Enterprises opens at £1.80, down 70p. They ‘gapped down’ traders will say.

Share prices are set by market-makers, who try to set a price where the level of demand and supply will be equal. If the market-makers opened the price at the £2.50 level, they would have a deluge of sell orders and would have to buy all of this stock. They would then be forced to cut the price to offload this stock, and incur serious losses in the process. So what happens is that the market-makers guess the price level where the sale orders (from traders who want to bail out), and the buy orders (from traders who believe the shares are good value after the fall) will be approximately equal. Their guess is that level is at £1.80. If they are right then some traders will sell their shares at that price, and other traders will buy at that price.

However, if the market-makers have priced the shares at a level that is still too high (i.e. there are lots of sellers and very few buyers), then they will have to lower the price further. Alternatively, if they have lowered the opening price too much (i.e. there are far more buyers than sellers) then they will raise the price.

In practice, what I generally find is that the market-makers anticipate they will have more sellers than buyers in the above instance. They open the price sharply lower, take this stock on to their books, and then try to push the price up during the day as bargain hunters come in to buy from them.

Conversely, when a company announces good news, the marker-makers anticipate that they will have more buyers than sellers. They mark the share price sharply higher, sell stock at these high levels to investors, and then try to push the price down.

My Strategy For Trading Price Gaps
A trend will often develop in the first two hours of trading. Let’s say that in the above example the share rises to £2.05 after two hours trading. This usually means that the market-makers are long and are succeeding in pushing the share price upwards. My strategy is to jump in with them and also go long, and hopefully take profits towards the end of the session.

If however the shares fall further and are trading at £1.60 two hours later, this usually indicates that the market-makers did not cut the price by enough when they opened it at £1.80. I would jump in against them and go short, and hopefully close out at a profit before close of trading.

It should be noted that the market-makers get it right more often than not, so the first example of possible trends, above, is more common, in my experience. All of this assumes that nothing else of significance happens during the day to change the level of demand or supply for the shares, and of course that is not always so.

My Rules For Day Trading Price Gaps

1. When a share gaps down, the low for the day usually occurs during the first hour of trading. The shares then rally from that point, and close still down for the day, but well off the low.
2. Conversely, when a share gaps up, the high for the day will usually occur in the first hour of trading. The shares fall from that point, still closing up on the day, but well off the high.
3. When a share gaps down, and then continues to fall for the first two hours of trading, then it usually continues to fall for the remainder of the day.
4. When a share gaps up, and then continues to rise during the first two hours of trading, then it usually continues to rally for the remainder of the day.
5. The intra-day trend for Irish and UK stocks can be disrupted by the opening of the US market at 2.30pm our time (9.30am US Eastern time). If the US market opens sharply down, it usually depresses everything in Europe. And visa versa. Investors begin to anticipate how the US market will open from about 1pm our time onwards.
6. The above rules also apply to the overall market i.e. the FTSE, Dow, S &P, Nasdaq etc.
7. There is no rule that works every time on the stock market!

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