Understanding The Basics of Trading Gaps
Gaps occur within our trading charts when the price of a particular security moves sharply up or down with no trading happening in between. These can result due to a variety of factors including economic events, fundamental analysis results, or in this case, earnings announcements.
Earnings announcements often cause significant price volatility in the market. These announcements provide information about a company’s financial health and future earning potential; thus, investors wait with bated breath for these announcements. Depending on whether the data is positive or negative, stocks can gap up or down.
Step 1: Identifying the Gap
In trading gaps up (and down) after earnings, the first step is to identify the gaps. This is usually done using technical analysis, specifically looking at charts. A gap up refers to when the minimum price of a day’s trading is higher than the maximum price of the previous day. Conversely, a gap down refers to when the maximum price of a day’s trading is less than the minimum price of the previous index day. The strategy is simple in theory – buy low and sell high, but it’s easier said than done.
Step 2: Analyzing the Gap
The next step is to analyse the gap. This is done by looking at the company’s earnings report. If the earnings report was above expectations, the price may gap up. If it was below expectations, the price may gap down. Do not rely solely on the earning report, evaluate the overall market direction- is the market trending or range bound? How strong is the trend? This will help you in assessing the potential of the gap.
Step 3: Volume Confirmation
Volume is an essential indicator to confirm the strength of a gap up or down. A significant increase in traded volume compared with the previous session or average volume shows strong investor interest, which might cause the gap to continue rather than being filled. If the security gaps up on high volume, it’s a bullish signal, whereas if there’s a gap down on high volume, it’s bearish.
Step 4: Planning Your Entry and Exit Points
Before trading the gaps, you must establish clear entry and exit points. Look for support and resistance levels on the chart history to help you decide these points. You can open your position right after the market opens or wait until the price retests the gap area. If the gap is not filled, it could be an opportunity to enter a trade with a target price at the next resistance level for a gap up or the next support level for a gap down.
Step 5: Gap Fading
Be careful of gap filling or Gap Fading, where the price moves back to fill the gap shortly after it is created. This frequently happens, particularly around earnings announcements, as traders take profits after the initial surge. Therefore, always have stop-loss in place to avoid unexpected losses if the gap closes.
Step 6: Managing Risk
Trading gaps that occur after earnings announcements can be risky because the price could move in either direction very rapidly. It is crucial, therefore, to have a thorough understanding of risk management. This includes knowing how much capital you are willing to risk, setting stop-loss orders, and not investing more than a small portion of your trading capital in any single trade, among other strategies.
Final Thoughts
Trading gaps up and down after earnings can be profitable, but there are intricate dynamics to consider before entering into a trade based on this investment strategy. It is recommended that new traders start by paper trading to get a feel of the market dynamics and gradually transition to real trading once they have a tested strategy in place. Always remember, trading is not about making quick money, but about strategizing, planning, and maintaining strong control over your emotions.
