How to Trade an Opening Gap Down

An opening gap down provides a potential trading opportunity and is one of the more profitable stock trading strategies for those who are ready ahead of time.

I say "for those who are ready ahead of time" because if you aren't already on alert for thse kinds of moves to begin with, you'll likely get caught up in the excitement and potentially be on the wrong side of the trade.

By being on alert and having a plan of action in place BEFORE an opening gap down occurs, you'll be able to stay calm and have a pre-determined course of action to follow.

First, let's go over what an opening gap down is: An opening gap down is when prices open up the regular trading session considerably lower than the previous days closing price of the regular trading session.

It can be seen on a chart by looking at a chart displaying multiple days at once. You can see them occur, and find them on a 2 day chart but once found, I like to take a further look at them on a 5 day and 10 day chart also.

By looking at these charts with 5 or 10 days, I feel more comfortable because I can try and find prior support and resistance levels to watch for also.

Now, let's go over what can cause these to occur: This particular signal occurs due to some kind of news event which drastically changes sentiment in the specific stock (or market index/etf)

Example news events could be earnings reports that miss expectations; death, departure or changes of a significant member of management; SEC lawsuits; FDA rejections, etc.

Prices "gap" lower because of increased and intensified fear about the particular stock which results in a large number of orders from people wanting to exit their positions immediately. If the number of sell orders is so much larger than the number of buy orders at a particular price, prices move lower quickly until enough buyers step in to fill the existing sell orders.

One example that just occurred yesterday was the announcement of Apple CEO Steve Jobs stepping down from his day-to-day duties to concentrate on his health. The news came out last night on 01/17/2011 after hours and then this mmorning, Apple (AAPL) had an opening gap down.

Price of AAPL closed the previous regular trading session on 01/14/2011 at $348.48 and opened this morning on 01/18/2011 at $327.05, 6.15% lower than the last closing price. That's a significant move and thus a gap due to the large difference between closing and opening prices. Here's a 5 day chart displaying the opening gap down:

Opening Gap Down

As you can see on the chart above, prices opened lower and basically bounced and never went below the opening lows of the gap down. (on top of the continued move higher during the regular trading session, Apple reported their earnings results after the close and the price went even higher after hours).

So how can somebody take advantage of something like this when it, rather, AS it happens? In the example above, if you feel the move lower is perhaps overdone, then entering a new long position with a stop loss below the morning lows is one way to take advantage. This would mean you feel that the move was overdone and are expecting the "gap to be filled", at least somewhat.

Another scenario that could occur is there could be an opening gap down followed by a bounce, but only a small bounce and then a continued move lower. In this scenario, prices may either re-test the prior lows and then move higher or just move right through the prior lows and continue to decline. That's why a stop loss must be used in all cases as prices can move very quickly on these types of moves.

Before using this as one of your stock trading strategies, be sure to do some more research and see how prices usually react in similar situations. You'll get a feel for how often prices bounce and "fill the gap", as well as how often they do not.

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