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 MARKET REPORTS |
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Resident Trader
Dealing with market gaps
Will Kraa, September 11, 2008
Monday (8 September 08) was one of those rare days when the market jumped up by about four percent, a large move of nearly 200 points. You would think when hearing this that day traders could have made lots of money from such a move. Unfortunately that is not the case unless you had a position open over the weekend. Most of the move was in the form of a large gap that saw the market open this morning at close to a hundred points above the close for Friday. Similarly most of the big moves in individual stocks were in the form of substantial gaps between the Friday close and the Monday open.
Some examples were CBA, which on Friday closed at $41.59 and opened today at $43.20 and MQG which gapped up from $42 to $45.50. Oddly enough BHP, which has gaps in its chart all over the place, did not gap at all today. This is not too surprising seeing the sudden burst of enthusiasm was generated after the news of the financial bail-out of the mortgage giants by the US government. You would expect that would affect the financial stocks more than the resource ones. It is also interesting to observe that, during this time when overseas financial woes are creating great volatility in our market, the chart of the usually stable CBA has lately shown lots of large gaps while BHP has been positively subdued in comparison.
The conventional wisdom is that gaps in the chart are often covered by subsequent price action. So how can these gaps be handled by the short term trader if there is a probability that the price may retreat to fill the gap? Also there is the problem that after the gap, even if the price does not retreat to fill the gap, the subsequent price action is very minor compared to the previous gap in price. It may well be that the intraday trader will miss out on most of the benefit of the jump in price that makes everyone else very happy.
One way of trading after gaps is to test their strength by waiting till after the first half hour of trading is over. If the price starts to fall after the opening and does not recover then it is obvious that the gap was due to unwarranted optimism. In these cases the only thing I do during the first half hour after the opening is to wait and watch. If the stock is still trading above the opening price after the first half hour I then wait for the stock to trade above the high of this period. If it has gone up by too much during this time I tend to lose interest unless there is some reason to expect a very large move. My initial stop for the trade will then be placed just below the opening price.
Today (Monday) I noticed that Woodside Petroleum gapped up from Friday’s price by $1.52 as you can see on the chart which is updated to Monday 08/09/08.
There had been no increase in the price of oil to justify the rise so there was a possibility that this gap was simply due to the burst of optimism in the market after the “good” news from the USA. I therefore decided to wait and see what might transpire during the first half hour. The price held quite well after the open at $57.50 and in fact the low for the day was only a few (six) cents below the opening price. After the 30 minute wait the price was above the high for the first half hour of trading and I decided to put in an order at $57.85, just above where the market was trading. By the time my order was placed there were no sellers left at that price and my bid was soon trumped by other buyers as the price quickly rose higher than the price I was prepared to pay.
For a while it looked as if I was not going to have a trade and then I noticed that prices were slipping down again. I amended my order and was able to buy the 1500 WPL at $58.08, a little higher than my liking but still not too far. My mental stop was just below the opening price for a risk of around 50 cents per share and a total risk for the trade of $750, an amount appropriate for the account I was trading.
Soon the price rose again and continued up to the high of $59.52 and then started to fall again. The stock closed at $58.21 but by that time I had taken my profit some time ago. I was able to get out at twice the amount risked at $59.09 for a gross profit of $1515. The way I manage these trades is to move the stop to breakeven once the price has gone up by the amount of the initial risk and then to move it up to twice the initial risk above the opening price once the price has gone above that. Otherwise the trade is closed at the end of the day. The objective is to protect and, if necessary, take a profit of twice the initial risk. Seeing the initial risk of this trade was 50 cents, the profit objective was $1.
This was one of those days when the best part of the daily price rise was in the gap from the previous day. My profit was in the ‘tail’ above the candle since by the close the price had fallen to near the price where I had opened the trade.
Another interesting feature on this chart is shown in the candle marked by the green arrow. Notice that the price had risen substantially for several days on increasing volume. The day marked by the green arrow had an exceptionally high volume and a large rise in price and is a typical example of enthusiastic buying where all the keen buyers finally get the stock they want and the number of keen buyers subsequently dries up. The result, as seen on this chart, is a fall in prices. It is often the amateurs who buy at these times and the professionals who are very happy to sell to them. Those who buy at these times often lament the fact that whenever they buy, the price falls.
NOTE
I have been asked at times what causes the gaps from one day’s trading to the next. It usually only happens in markets that close for the night. The next morning there may have been some good news about a stock or the market as a whole and lots of people are very eager to buy. Before the market opens for the day it is possible to place orders into the market to sell or to buy. Computers at the exchange calculate a volume weighted ‘match’ price taking into account the buy and sell orders and their sizes. As people see these prices they may place orders above the match price to try to ensure they will get their orders filled. This may have the effect of moving the match price up and if some buyers are keen enough to buy they may adjust their bid price up again and an ‘auction’ ensues.
The result is that the ‘match’ price at the time the market opens for each stock may be substantially higher than the closing price of the previous day and this then becomes the ‘opening’ price. On a chart it will show as a gap between the closing price of one day and the opening of the next. The same thing can happen in reverse when there is bad news and there might be a downward gap. There is a similar ‘auction’ at the close of the day. The market closes at 4 pm but orders can still be placed into the market until 4:10 pm when again the computers find the volume weighted average price which is the ‘match’ price and all the orders that are in suitable places in the queue are done at the same time at the match price which then becomes the ‘closing’ price.
This match price may not be the same as the price of all the orders filled. For example, if you place an order to buy at say $6.40 and the match price at the moment the computers do the ‘auction’ trades is at $6.25, your order will still be filled at the match price of $6.25. It is one of the advantages of Direct Market Access CFD providers that it is possible to participate in the opening and closing auctions.
More articles from this edition of CompareShares:
Investing: Top places to invest $500, $1000, $3000 and $5000
Resident Trader: Dealing with market gaps
Investing: Get this right - the magic formula to a top-performing portfolio
Oil: OPEC cuts output to shore up market
Reports: Gen Y investors take bigger risks
Commodities: Oil prices continue to fall
Companies: Cleveland Cliffs looks to mop up Portman
Whatever your views, you can discuss this article - or any of Will's articles - on our message board Your 2 Cents.
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