Characteristics of a Morning Gap

It will be important to understand a few key elements before we dive into the specific strategies; such as volume, volatility, and risk tolerance.  You will need to understand these building blocks in order to have a more complete understanding of how to trade the morning gap.  Remember, you have a very short time window to execute your trades and you need to be able to quickly process all the clues that are given to you. 

Volume

Volume is probably the most important tool that you can have available to you.  We have done an extensive write-up on how to read the time and sales window (aka. Tape reading) which will provide you with the trading activity of each stock.   As a trader, you need to understand the significance of high or low volume, especially when it occurs at important support and resistance levels.

When we see high volume attacking a support or resistance area and pushing through it, it is a sign that the sellers or buyers are in control and that enough energy has been exerted to actually signal a continuation in trend for a larger period of time.  Generally speaking, you want to see a volume picking up as it approaches a resistance level and take it out with heavier volume in comparison to the previous volume figures recorded in the past at that same price level. 

Light volume; however, is not necessarily a bad thing.  Light volume can allow the stock to ramp much higher and much faster than if there was heavy interest in the stock.  This can be a good thing when the stock is in a confirmed uptrend and you are riding the trend higher.  But always be cautious of a high volume spike after a sustained uptrend, this could put a wraps on the move, at least for the short term.

Volatility

Be aware that it is very important to understand the principal of action and reaction.  For example, if a stock moves substantially higher over a 3 day period without any major retracements, a trader should prepare for a reaction which would be commensurate to the previous move higher.

When we see stocks moving extremely fast, up or down, there is a risk for high levels of volatility on the opposite side and this can signal large moves up and down, where emotions take over and technical analysis gets thrown out the window.  Keep this in mind when you select the stocks that you trade.  Higher volatility leads to larger swings which lead to irrational market movement. 

For this reason, I find it more beneficial to trade larger cap stocks which attract the big money, thereby reducing the massive levels of volatility that can be seen in small cap stocks.

Risk Tolerance

This sounds simple, but trust me, when you are in the trade it isn’t so easy.  Define your trading risk profile before you start trading.  Define the amount of money you are willing to risk and understand if a potential trading candidate fits in line with your risk profile.  Far too many traders think that they can approach a Dow component in the same way that they approach a Chinese internet stock.  Depending on your trading rules, a high volatility stock may take you out of an otherwise good trade due to the violent whipsaws that occur in these stocks.  If you cannot emotionally handle large swings, don’t trade the stock.  There is always another trade.  If you still feel the need to trade these stocks, dramatically decrease your position size.  Remember, consistency is the key in this game and you do not want to disrupt that with large losses in the account, no matter how much of an itch you get.