Understanding Gaps: Why do they exist?

[Soultrader]

Let me begin with a simple definition of a gap. A gap is the difference between the previous days close and todays open. For example, in order to set a gap chart you would set the close of a S&P emini chart to 4:15pm eastern and the opening to 9:30am eastern. Any action that takes place overnight which shifts the closing price is a gap.

Why do they exist?

Gaps exist due to a variety of reasons. Buyers/sellers may need to unload their inventory aftermarkets causing an imbalance in supply and demand. Significant overnight news can cause market participants to react overnight shifting price. Smaller gaps of less than one S&P point should not be considered significant while larger gaps of 6 S&P points or more should keep you alert. Here is the reason why:

Most gaps fill in the same trading day. Therefore it is crucial to understand whether price is accepted or rejected at these new levels. One way to determine this is to scan premarket volume for SSF's (single-stock futures). A full comprehensive list can be obtained here. When the SSF's trade significantly above average volume during the premarket, there is a good possibility that the gap will be a professional gap. In other words, the gap will continue in the direction of the gap and will not fill. Another method I use is to determine price has gapped away from yesterdays value and range. If prices do gap above/below value area and are accepted by the markets during the first 5 minutes of the opening session, I look to go with the gap.

A professional gap is not the norm but the exception compared to the amount of gaps that do end up getting filled. Always ask why the gap occurred and when you can not find 2 good reasons, there is a chance for a gap fill.

[Soultrader]

Thread discussing the opening gap play.

http://www.traderslaboratory.com/for...8-17-06-a.html

[ezduzzit]

Soul: Very interesting idea scanning the pre-market volume of the SSF's. I had never come across that before and thanks for providing the link for the listing.

Happy Trading! :-)

[Soultrader]

Glad it helped.

Its always a good idea to look for clues to why the markets gapped up as much as it did. I usually start by going over any economic number that came out. There are several extremely important ones and alot of mediocre ones. For example, if the CCI, Employment Situation, GDP, etc.. and the markets gap I will be careful. These numbers can often cause a contiunation gap. If the economic numbers are not as significant, I will then look at the SSF's to see if there is any action premarket.

There is an excellent book called, The Secrets of Economic Indicators by Bernard Baumohl. I often use this book as referennce since I am from Japan and not familiar with all the different economic numbers.