In today’s option trading blog I will discuss gaps. If you believe in efficient market theory than everything is priced in to a stock every moment and a move is a random, unpredictable event. As the theory goes, you should just put your money in an index fund and a bond fund because you can’t outperform the market. In the era of full disclosure, that is more the case now than ever. Information flows freely and there are fewer “secret handshakes” than ever. I don’t believe in the theory and I am able to find opportunities on a daily basis. However, let’s say that I did believe. What happens when the unexpected ocurrs – a gap.

The market scrambles to assess the news and to weight the importance of the event. All of a sudden, imbalance and chaos exist. This is the environment I seek. The market hates uncertainty and the reaction can be very telling. Down gaps are my favorite because they can lead to big drops. Here’s my angle.

I define a bearish gap as a stock where the high today is below the low from the prior day – it is a true gap. If the low price for a stock yesterday was $42 and the high today was $41, it qualifies. The move was so pronounced that the stock could not even rally to $42 intraday. This tells me that there’s a crack in the dam and the stock is weak.

There are many keys to trading gaps, here are two. First of all, where is the stock in relation to the 52-Week range? I’m much more interested in a down gap on a stock in the upper quadrant of the 52-week range than a stock that has been in a free fall. Why? Because everyone is long and panic and profit taking can easily set in. For that same reason, I’m more interested in stocks with high P/E ratios and “lots of promise”. If the resistance level is defined (long term horizontal) I can be pretty sure those highs will not be tested soon. Option traders… do you see the implications?

The second key is to watch the reaction the second/third day. If it was a big gap and it filled in easily, the news may not have been material. If the stock tries to bounce and “fill” but it fails and makes a new low on a steady drift lower, it has more room to fall. You should always read the news and determine the reason for the gap. An analyst downgrade means nothing, those gaps will fill. A material change in earnings guidance… now that move could have legs.

I can make a living just trading gaps. I have a scan that shows me gaps that are up to 4 days old. Sometimes the older the better. If you are a OneOption subscriber, click on the Scanner and try it out. You will get a one day pass. If not, Register and try all of the research free (including 5 reports). The Scanner will show you at least 300 new stocks each day and the charts are integrated.

What’s your favorite set-up? Tell me and I’ll share my thoughts.

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