August 10, 2007 at 8:19 am | | Comments 2

How Gaps Change Motivations in the Market

With so many gaps hitting the market in recent days, it’s the perfect time to discuss them a little bit. Not only are they occurring in individual stocks as a result of earnings announcements (which is typical and expected), but we’re seeing a lot of them in the market indexes with the recent news flow adding to the volatility. Of particular note is how many of them have filled.

Before I get to the heart of this article, let’s look at an example in case you’re not quite sure what I’m talking about. Here’s a look at a 5-minute chart of the NAZ on Thursday morning, which gapped down some 40 points from Wednesday’s closing levels. It ended up rallying back up to fill the gap soon afterward, and even turned positive for the day after about 90 minutes.

(Click for full-size image, courtesy of TeleChart)

The Mechanics of a Price Gap

So how do these price gaps even come about? Well, they occur from a buildup of orders overnight which create an imbalance between buyers and sellers. Market makers and NYSE specialists have to take the opposing side of the public’s orders (they buy when you sell and vice-versa), so to offset this risk they do it at higher or lower prices, depending on the imbalance. When the public is buying en masse, market-makers will sell but at higher levels. That’s how gaps are created.

Once they’re in place, the next question is how do they get filled? Well, since many of them lately are occurring on emotional reactions to the news flow, most of the traders who would act on the news are the ones creating the gaps. After their orders build up which create the gap to begin with, there are very few traders leftover placing subsequent orders in the same direction, thereby limiting the extent of any follow through. As a result, the path of least resistance shifts to the other direction, meaning the gap now has greater potential to fill.

Psychology’s Role in Gaps

On top of the mechanics of how the gaps are created and filled, there’s also a lot of psychology at work which is adding fuel to the fire. Traders who are already holding positions in the direction of the gap are greatly tempted to take those profits, which means on a gap up that they create selling pressure as they move to book gains. The overnight windfall of “free money” motivates them to ring the register, and that only accelerates how quickly the gap may fill, especially when combined with the natural mechanics of a gap. Additionally, downside gaps are often viewed by those with cash on hand as an irresistible sale, unable to pass up the thought of buying “cheap” stocks. Their buying, along with the covering of short sellers, drives prices higher to fill the gap.

There is never a shortage of interesting dynamics at work in the market, and price gaps are a study in the psychology which can help us learn a lot about why things move the way they do. If you catch a gap in your favor, play it close to the vest and squeeze out of it whatever you can, but if it begins to fill just remember how momentum is shifting and decide quickly whether you want to battle it or not.

Jeff White
President, The Stock Bandit, Inc.
Swing Trading & Day Trading Service

[tags]Stock Market, Day Trading, Stock Trading, Investing, Swing Trading[/tags]

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