Tales of a Technician: How to Deal with Price Gaps
Price gaps are a pain. They rob traders of ideal entry points and throw a wrench into clean price patterns. This morning’s monster price jump was merely the latest episode of a manic market denying spectators an optimal entry to Friday’s fire sale. Lest you’re unfamiliar with the nature of price gaps, allow me to bring you up to speed.
The regular trading hours for the U.S. stock market are 9:30 am to 4:00 pm EST Monday through Friday. But when the closing bell rings, it doesn’t mean that price movement necessarily halts. When news strikes or overseas markets throw a tantrum, U.S. stocks can still respond in the after-hours market. This takes place either in the equities themselves (like AAPL, MSFT, SPY or whoever) or via the futures market. Remember, even though the S&P 500 cash index (SPX) or ETF (SPY) may be closed for business, its futures contracts are still bucking and jiving all night long. And since all three products are tied at the hip, any overnight shenanigans in the futures market will directly impact SPX or SPY at the open. The will immediately gap higher or lower to compensate.
That’s precisely what we saw this morning. The futures market opened higher on Sunday night and proceeded to ramp until this morning. SPX and SPY, then, had to gap up some 1% plus right off the bat. While that’s great for anyone who entered bullish trades on Friday, it effectively robbed everyone else of the ability to deploy new trades this morning at Friday’s depressed prices.
So, how do you avoid broad market gaps? And what, if anything, can be done to alter our approach to deal with them?
First, you can’t avoid them. They occur randomly, but do strike with increasing frequency when volatility is high (like now).
Second, if you can, then I suggest placing trades when the market is open. That way you can react instantly to adjust orders that didn’t fill.
Third, if you have to place trades after hours, then pre-market is better than post-market. In the morning you can check to see if the futures changed overnight. That way you can modify your orders accordingly to account for the price change. If you instead enter them at night, there is more time for the futures market to undergo a substantial change by the time the market opens the next morning.
Fourth, if the market does gap and you’re able to be in front of the market then re-asses your trade at the market open to see if it’s still viable. If the gap was too large, the prices might have changed too much to justify entering your trade. Don’t be afraid to walk away at that point and search for a better opportunity.
In today’s case, we actually witnessed a decent intraday selloff that partially filled the gap. If you were looking to deploy bullish trades then the prices did improve before the rally began in earnest. You may have had a chance to get filled closer to what was available on Friday. Suppose I was looking to sell an OTM bull put in AAPL that was trading for $1.00 at the close on Friday. Unfortunately, with this morning’s jump, the bull put opened at 70 cents. At that point I have three choices:
One, leave the order at $1.00 and hope that AAPL sells off enough intraday for the put spread to rise back to $1.00 in value.
Two, modify the price down to 80 or 90 cents to increase the likelihood I get filled into intraday weakness.
Three, curse the market gods for shafting me, cancel the order, and move on with life.
