Stocks were relatively calm today in what was supposed to be an exciting day. Tariffs on China were slapped on in the morning, and Uber commenced its first day of trading on the New York Stock Exchange.
However, there is still hope that a trade deal can be reached as negotiations are still ongoing so the market is just kind of hanging out here.
That said, I want to talk to you today about something exciting…
For example, Last Friday the SPDR S&P 500 ETF (SPY) closed at 294.03. On Monday, stocks opened up significantly lower after President Trump announced that the U.S. will continue to slap tariffs on Chinese goods.
That said, the SPY opened trading at 289.25 on Monday, a drop of more than 1.6% In other words, the SPY gapped down by 1.6%
(The spaces created between the closes and opens are called gaps)
Stocks can gap up or down. However, there is something special that occurs when we see gaps in indexes like the SPY.
In fact, we had a great discussion today in the trading room about how to use gaps in the SPY to find trading opportunities in individual stocks.
You see, during healthy trend days it doesn’t matter what stock you are in, there is a good chance it will be trading with the market. However, some of it might not make sense.
For example, some stocks have gotten beat up whose performance will not be affected by the tariffs. With the right gap signal (like the one I’m going to teach you now) you’ll be able to find low-risk and high probability trades to take.
Now, if you don’t know what “gaps” are, listen up. It’s basically when a stock opens higher than where it closed… or opens loser than where it closed the previous day.
As someone who likes to use charts, knowing where the gaps are on a chart helps a lot.
Today, in the Petra Picks chat room, I was getting some questions about how to play gaps.
Is there one right way to play gaps?
You see, there are a few ways to trade gaps. For example:
- Some traders like to play for the gap fill. In other words, if a stock has gapped up… they’re looking for the stock to trade back to where the stock gapped up from.
- Other traders will look to fade the gap. That means they’re either buying the stock if it gaps down… and short the stock if it gaps up.
- You could also use gaps as levels to look for a reversal. (This is what we’ll be focused on today).
Now, the market has been experiencing quite a bit of volatility with the ongoing trade talks… and if you paid attention to your charts and the gap in the SPDR S&P 500 ETF (SPY)… you could’ve had some attractive returns today.
That said, let’s get right into a lesson on how to play the gap.
Reversal Trades with Gaps
Here’s a look at the daily chart in SPY on my trading platform.
Now, if you look at the chart above, you’ll notice a gap. The market gapped up on April 1 (SPY opened at $284.70, while the previous day’s close was $282.48).
There were two ways to play this trade. You could’ve shorted SPY or bought put options for the gap fill (looking for the price to get back below $283). On the other hand, you could’ve used that gap as a level to watch to buy for the reversal.
We were looking to play the reversal since we figured that would be a good area where SPY would hold and catch a bid.
Look At Shorter Timeframes and Moving Averages
When a stock or exchange-traded fund (ETF) fills a gap, it could create some great buying opportunities. Keep in mind, you don’t just want to look at one timeframe on a chart when you’re looking for gap plays… it helps to look at other indicators on short-term timeframes.
For example, with this SPY trade, I was watching the 10-minute chart and a price break above the 8-period exponential moving average (EMA). If you don’t know yet, the 8-period EMA is one indicator I use all the time, it gives us an idea of the price trends over the short term.
Here’s what I was watching in SPY on the 10-minute chart.
If you look at the chart above, you’ll notice a green line tracking the prices of SPY. Now, this green line is the 8-period EMA. If the price breaks above the green line, that’s bullish and you could’ve waited for the second candle stick to break above it before you got in.
So the trading plan could’ve gone something like this:
If SPY clearly breaks above the 8 EMA on the 10-minute chart, I’ll look to buy shares anywhere between $283.50 – $283.75, with a stop around $282.48 (where the gap was on the daily chart).
When you follow market index ETFs, like SPY or the Nasdaq-100 ETF (QQQ), you could also get stock specific and look to buy stocks that have sold off with the market… once you see the market reversing off a key gap area.
The whole idea here is to be aware of where the gaps are in stocks and ETFs that you’re trading… no matter how long they have been there. As you can see knowing where the gaps are uncovers opportunities.
Additionally, being mindful of where the gaps are could save you some money. For example, let’s say you’re long a stock that has recently gapped up… well, if you notice that, you should be wary if the stock starts to pull into the gap area because if it gets close… the stock could fill the gap, and you would end up losing money.