A "Gap" is a term used to describe the condition when a stock opens at a higher price than it closed the prior day.
The word gap refers to the space that is left in the daily chart. It is the "empty space" from yesterday's close to today's open.
Gaps can be either up or down and they can happen to all stocks and in all stock markets.
Gaps are measured from the prior day's closing price to the current day's opening price. The post market activity and pre market activity do not affect the gap.
Stocks can trade after market hours, and at pre market starting, but these are not considered "normal" market hours.
For example, stock X closes at 7.00. It trades in after market hours up to 7.50. The next day it starts trading at 7.20 and trades up to 7.60. Later in the day the stock is all the way down to 7.10.
The "Gap" as we measure it is only 20 cents (7.20 - 7.00). All those post and pre market trades do not matter. The stock traded, and people made and lost money, but the gap is not affected!
What causes gaps? Usually it is news driven. Individual stocks can gap up or down due to news such as earnings reports, earnings pre-announcements, analyst's upgrades and downgrades, rumors, message board posts, key people in the company commenting, buying or selling the stock.
Groups of stocks or the whole market may gap-up or gap-down due to various economic reports, news on the economy, political news, or major world events. These news can cause many individual issues to gap with the market.
Many stocks can move very closely with the market and others may be in the sectors that are mostly affected by the news.
Whatever the exact reasons, gaps are the result of some kind of events happening while the market is closed. The result is the buying or selling pressure at the opening of the next day, that will make the stock open at a different price than the one it closed.
Why are "Gaps" important?
This sudden move by a stock, the sudden change in demand, is often the beginning of a major move.
There are i.e. swing trading strategies that capitalize on entering after a gap, and other tactics like i.e. momentum trading that capitalize on several days moves after a gap.
Generally, never buy a large gap-up at the open and also never sell short a large gap-down at the open. Also, large gaps are already extended, making the "play" very risky.
We tend to "fade" the gap initially, if played at all. Fading means to play the stock to come back in to where it was. Fading a large gap-up would be to go short the stock as it trades down after a large gap-up.
In general, keep in mind that the stock is opening at a price that thousands of people have decided it should be trading at after digesting whatever news occurred.
You cannot look just at the news, and decide if the stock is "over-valued" or "undervalued." That defies the basic concept of technical analysis.
Keep your mind open to the fact, that regardless of any gap, for any reason, a stock can still move in either direction.
After the initial move, the charts must be looked at along with the amount of the gap, and the share price of the stock. Small gap-ups that gap over resistance should be favored for long entries.
Large gap-ups that gap into resistance should be favored for short entries. What is "large" or "small" and what is resistance is all a matter of chart reading and interpretation.
The daily chart, the extension of moves, support and resistance levels, and relative strength all come into play. Small gap-downs that gap under support can be watched for short entries.
Large gap-downs that gap above support can be watched for long entries. What is "large" or "small" and what is resistance is all a matter of chart reading and interpretation.
The concept of gaps is a very difficult one for most traders, even those with considerable experience. Gaps provide strategies all by themselves, and are part of many other strategies.
Study gaps all you can ...
Study them when they happen ...
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