Trading Opening Gaps in Stocks

Trend following trading systems work well for stocks. Any trend system will do. But, during earnings season, it is common to see a 5% or 10% move before the opening, which can either throw off a trade or enhance it. Yes, sometimes the jump is the wrong way, but not too often. It is best to take profits on the larger, favorable gap openings, or even before the open, and then wait for a better place to reset the trade. Then a trader can reenter the position by the end of the day to stay in line with a trend trading system.

Most of the activity is in the first two hours of the trading day. Linda Raschke has said that the mornings are mean reverting and the afternoons are trending. That’s because the economic reports and many of the earnings come out before the stock market opens, and traders are positioning themselves in the morning. By midday, everything seems to settle down and the prices take on more of a trending pattern.

 

 

 


Recently, a trader would have been able to profit on a jump of 10% in Boeing (BA), only to watch it go up 20%. It never pulled back, so that trader didn’t have a chance to reset. That was a problem, and when Sun Power (SPWR) and MasTec (MTZ) jumped the next day, they reversed a 5% profit on the open to a 5% loss on the close. Some days, you just can’t win. But, being adept at programming, I decided to take a more scientific look at what happens. Using the 275 stocks that I follow each day, I constructed a histogram of opening price changes, in percent, as follows:

Up 1% to 3%    Down 1% to 3%

Up 3% to 5%    Down 3% to 5%

Up 5% to 7%    Down 5% to 7%

Up 7% to 9%    Down 7% to 9%

Up 9% to 11%    Down 9% to 11%

Greater than 11%    Lower than 11%

Each bin holds the number of times a stock, and all stocks, opened in that range. For each bin, we then looked at the size of the pullback, in percent, from the open to the low (for upward opening gaps), from the high to the open for downward gaps, the close relative to the open.

As a big picture, we would then know the relative pullback given the size of the opening gap, and whether the close was above or below the open. We also can tell how much the price recovered from the pullback. That’s enough to let you day trade on those days with gap openings.

Upward Gaps
First, we’ll look at the upward gaps (see “Upward gaps,” below). It shows what we already suspected. Most of the upward gaps, occurring on 31% of the days, are between 1% and 3%. Prices pull back a good portion of the gap, generally more if the gap is larger, after which prices close very near the opening price. The pullback reflects a normal volatility relationship. It’s safe to say that, in general, the pullback is about 40% of the gap.

 

 

 


This should give us a good idea of how to trade a gap opening, if you’re holding a long position: Take profits, wait for the pullback and then reset your position. You should expect to gain anywhere from a 1% to a 4% if you started the day long, but individual stocks and erratic price movements may make that much better or worse. If you had no position and just wanted to be long, you could capture about 40% of the opening gap outright by entering on the pullback.

Note that the gaps for any stock trading under $5 were ignored. Experience has shown that those prices can be unusually volatile and can distort the results. In addition, some stocks, including Apple (AAPL), have been back-adjusted due to splits, and the oldest prices are negative.

Downward Gaps
We know that the stock market is biased to the upside, and downward gaps confirm that pattern. “Downward gaps,” (above) shows that there are somewhat fewer downward gaps than upward gaps. Pullbacks (to the upside) are a little larger, and the average of all stocks shows that prices consistently close higher than they open, a vote in favor of upward bias.

If you’re a day trader, long-only, you can buy shortly after the open (volume dropping usually indicates that the sell-off is ending), then sell on a rally of about half the gap down. If you’re holding a long position when prices gap down, you can exit on a rally of about one-half the gap, then reset on the close, trimming some of the loss.

How different are specific stocks compared to these averages? Let’s look at some of the more active and more popular stocks (see “Gapping stocks,” below). All but one is high-tech, but each is different. J C Penny (JCP) is the only retail stock. The upward gaps are shown first, and the downward gaps on the line below.

Using Apple as an example, there are 111 days where price gapped up between 1% and 3%, but no days where it gapped up more than 11%. However, there was one day when it gapped down more than 11%. Pullbacks were between 1% and 3% for upward gaps, with the exception that the one downward gap of 9% to 11% rallied 15.32% and closed 9.07% above the open. That must have been a volatile day.

JC Penny shows a more classic pattern in its pullbacks, larger as the gap gets larger, and four days with gaps more than 11%. Penny has been trading at lower price levels, so there is a tendency to have larger moves. Note that both the upward and downward gaps close mixed relative to the open.

You can get a better understanding of the opportunities by looking at the close relative to the open, shown in the right panel of “Gapping stocks.” In general, stocks that open higher or lower tend to close near the opening price. There are a few exceptions, but they seem to reflect single events, such as the Netflix (NFLX) upward gap of 9% to 11% that closed 16.68% lower than the open.


Recommendations for Gap Trading
Gap openings consistently have pullbacks, usually in the first two hours of trading, and eventually close near the open. That gives you a working set of rules for day trading. It’s still better to start by exiting a trend position already in your portfolio when you have a windfall profit, rather than trying to buy a dip or sell short a rally. If you don’t get back in at a better price, you’ve lost the opportunity for the trend trade, but you’ve lost real money for a new trade. My experience is that good earnings and upwards gaps are most often in the direction of the trend, so it makes for much easier pickings.