How to play gap ups? Part 3

I thought, it being the weekend, I would complete the series I started earlier this week on how to play gap ups. The first two part of the series which deal with the psychology behind chasing gap ups can be found here (Part 1) and here (Part 2). If you often find yourself buying at the top, I would recommend reading these early posts in the series.

Now, let's finally get to playing stocks which have gaped up. The following comes from my experiences in playing gap up stocks, or to be more specific, from what I have learned by my mistakes in my early days of trading in playing gap up stocks. Now obviously, all gap up stocks are not created equal. But in my experience, successful gap ups stocks mostly display some similar characteristics and I will try and go into these characteristics.

To me, first and foremost, the most important thing in successfully playing gap up stocks is closely observing the stock in the pre-market. I am sure you readers haven't read about this point anywhere, but like I said, this post comes from my own experiences. Now you might ask, why is observing the pre-market so important in case of gap ups. Variety of reasons dear readers:

(1) Technical - Say, this particular stock was in your watchlist for today and you had a particular buy point. Now, the stock is gapping up above that point in the pre market. So, its important, to know the new immediate support and resistance points for the stock in the pre market. The resistance point in the pre market can be an important entry point as described later. You also should be paying very close attention to volume in the pre market. If the volume is not relatively very high, forget about chasing the stock. In fact, it might make a good short on open.

(2) Psychological - Say, you don't follow the pre-market and open your broker terminal at 9:30. Now, you see that the stock which you were planning to buy today has gaped up well above your buy trigger. As I had mentioned in the previous posts, now the feeling of frustration and anger at missing out on profits starts setting in and you might find yourself buying the stock just to get rid of these emotions. You have no plan in this case as you are not prepared for the gap up. Odds are you are buying at the top and will lose money. So, observing the pre market is extremely important in getting yourself physiologically prepared for the gap up.

(3) News - Observing the stock going much higher in the pre market will give you enough time to look for and digest the news behind the gap up, if any. If the stock is gaping up because it was highly recommended by a newsletter or a tv show last evening, avoid it. The chances are its most probably people who don't know any better chasing the stock thinking its the next big thing and making it go higher. Smart money will soon take their money. Also, if the stock is going up for speculative reasons, like say some pending FDA news, it is best to avoid it or at least know at what time the news is going to come out, so that you can get out before the actual news. Buy on rumors and sell on news is a common adage that mostly works.

So, that's the reason for closely observing the stock in the pre market. Now, let's say you have closely followed the stock in pre market and everything seems good - high volume, positive news etc. Now the question is when to enter the trade?

(1) I would just enter an order just above previous close just for the heck of it. You will be surprised how many times a stock will quickly spike down just for a few seconds so that there is no gap and go back again.

(2) If the stock gaps up above an important resistance, wait for a successful test of this resistance, which has now become support, and then enter the stock. For example, the chart was forming an ascending triangle until yesterday and today gaped up above the horizontal line, wait for a bounce off this horizontal line before entering the stock.

(3) As you were observing the stock closely during the pre market, you know the price level where the stock was facing resistance in the pre market, enter on a break of this resistance with heavy volume.

Discipline is very important in any kind of trading, but especially important in case of gap ups. Your stop should be below the gap support or the previous days close, depending on your risk tolerance. Remember to respect your stop as the gap may very well be an exhaustion gap.

I hope this series of posts was of some help to you readers. I will be back tomorrow with some stocks worth keeping an eye on next week. Take care and good luck!

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