Few things test a trader’s nerves like a sharp gap at the opening bell. The screen flashes red or green, and within seconds decisions must be made. Following the Global Market overnight can prepare you for such moments, and the pre-market reading of SGX Nifty often hints at how large a gap might appear. But hints are not certainties, and preparation matters more than prediction. This article explains what gaps are, why they happen, and how to plan for them in a disciplined way.
What Causes a Gap?
A gap occurs when the opening price of an index or stock differs vastly from the previous close to create a blank space on the chart. This happens due to news that gets disclosed when the exchange is shut, such as results declared or policy statements, a steep rise or fall of foreign indices or geopolitical developments.
Since there is no trading in the domestic cash market overnight, accumulated buy/sell pressure gets executed at the open, causing a jump in price. The bigger the news, the wider the gap, as there would be more traders willing to immediately take up the opportunity. Traders classify gaps, based on their experience, to understand their significance. A common gap is an insignificant one that is quickly filled. They can be further split based on whether they are breakaway (when prices jump out of consolidation), a runaway gap (a repeat of a runaway gap during a trend) or an exhaustion gap (signifies the end of a long trend).
Traders look out for news, volumes and context before classifying a gap. It is important to understand that a gap that is heavily volume-weighted and has a news tag is much more significant than a gap that arose due to thin volumes in a low-liquidity counter.
Preparation before the opening bell
Use the free time before 9:15 smartly to read up on news that might have impacted your stocks. It is best to note down the crucial technical levels of the stock you are holding or have watched. Observe the pre-open session (which runs from 9:00 to 9:15) when indicative prices are found via an auction, as opposed to early indications from other sources. Set up alerts and decide upon your course of action ahead of time, including whether you would square off profits on a favourable opening or book losses on a poor opening. Decide if you would average down in case the index opens sharply lower or hold on to your positions. The best way to not get carried away is to plan your actions.
Trading approaches for gap days
There are two schools of thought on gap days. Some traders prefer to fade the gap, i.e., take a position in the opposite direction of a gap assuming that it will be closed. Other traders prefer to jump on the gap and run with the trend, especially if the volumes so indicate. Both approaches have their risks and there are no absolutes.
It is best to take a wait-and-watch approach where gaps are seen and not taken. You can decide after the first fifteen minutes if the price has closed the gap or not and decide your positions from there. Use a stop loss and keep your position sizes small since prices are likely to be volatile on gap days. If there are large volumes, you can consider booking profits as the price may have already reacted to the news.
You must be particularly wary of a share that is gapping on rumour or social media. The stock is likely to reverse on value discovery and it is better to stick to firms where news of a change in fortunes has been officially disclosed via the exchange.
Managing risk and emotions
Gaps can lead to slippage where your stop loss order gets executed at a much worse price due to a big gap. This is a particular risk to those who hold positions overnight. Position sizing is critical if you are a day trader since the risk of an adverse gap should not exceed your risk parameters.
Do not be tempted to chase losses due to a bad opening. Revenge trading can lead to further losses and it is best to cut losses at a certain threshold, say your daily loss limit.
Long term investors and gaps
You can ignore gaps if you are a long-term investor. After all, every day is a gap day! However, a sharp fall in the price of a stock you wish to hold can be a good opportunity to add more to a good company, provided you have the risk capacity. Maintain a systematic approach to buying and always focus on the fundamentals. Diversify your holdings to manage risk and utilise a long-term view to overcome the emotions of the day.
Preparation, patience and risk management can negate the stress of the opening bell.