Don't Fall Into the Gap

 | Nov 23, 2012 | 6:45 AM EST  | Comments
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When it comes to trading strategies, one of the toughest plays to execute is off an opening gap. When the market opens lower -- as it did Nov. 16, for example -- the move necessitates some patience as you wait to see if or when a bottom is achieved. A gap up, meanwhile, is a tough mental challenge: Do you jump on board and go long as the train is quickly gathering steam, or do you fade it?

These days, market momentum is the great equalizer. If you get on the wrong side, you'll pay the price -- and I myself have had my share of good and bad results. Often when I'm on the right side of a trade, I will use the strength or weakness to unload positions. I will rarely open new swing trades -- though I may do some intraday trading -- as these extreme moves are unlikely to follow through. If, perhaps, there is some continuation, there should be some safe entry points.

A gap will play games with your mind, as it comes with more "shock and awe" than does a smooth open that trends all day long. Why is that? Gaps tend to be faded because the moves are excessive, fierce and extreme. Your mind tends to get twisted as you contemplate whether to fade it or go with the flow.

This decision is where big money is constantly won or lost. You really won't have much edge unless the conditions are perfect for your style. Go "too far, too fast," and at certain levels the selling -- or buying -- will commence. On Nov. 19 the markets gapped higher and nearly made session highs in the first 40 minutes of trading. Then the indices leveled off and stayed high for the entire session (see chart below).

S&P 500 -- 1-Minute Chart
Source: Charles Schwab

My advice would be to avoid playing the gaps unless you are willing to play it light, be nimble and just accept smaller gains. There' nothing wrong with being just a little right.

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