Lessons from the Pros

Gaps, The Novice Trader Exposed…

Why do I write about gaps so much? Why do I make gaps such an important part of the Extended Learning Track (XLT) program? Simple, because gaps are the most obvious way to spot a novice market speculator. Remember, if you can’t spot the novice, consistent losing trader in a market, it is probably you. Just like the game of poker. If you sit down at the table and can’t figure out quickly who will pay the table that night, it is likely you.

Gaps in price are great because they are the picture of the ultimate supply and demand imbalance when you understand them. Not every gap sends the same message so we structure them into an understandable checklist. Once this is done, we can use this information to spot the novice market speculator and be there to take the low risk, high reward, and high probability trade from that novice trader.

Above is a chart of the NASDAQ including yesterday’s price action. In the XLT that morning, BEFORE (the big red candle) the market opened and collapsed, we were going over the stock market. We do our analysis when the market is not open and moving so we can be very objective and plan our trades in advance to take care of the emotion issues related to trading. I pointed out that just the day before, there was a gap up in the market (noted on the chart above) AFTER a rally in price, in the context of a downtrend, and INTO an area of supply (resistance). This is the most potent novice trader signal because it represents such a huge mistake. Anyone who buys after a period of buying and at price levels where supply exceeds demand is going to lose over time; the laws of supply and demand ensure that. The only action worse than that is when that person is buying a gap up and that is what we had above. What we did next was look at where the demand was below and determined it was much lower. This set up a scenario that suggested the path of least resistance is down and Wednesday proceeded to turn into a very down day once the market opened. Could I have been wrong? Of course, that’s trading which is why we focus on risk so much. Our goal in trading is not to create certainty because that never exists. Our goal is to become masters at objectively assessing the odds and that is what we did.

Let’s get back to gaps… In the XLT, we keep it simple. Here are some rules to keep in mind when you have a gap:

1) A gap up in price, in the context of a downtrend is a VERY high odds shorting opportunity.
2) A gap up in price, in the context of an uptrend is a lower odds shorting opportunity and actually can be a buying opportunity when there is a significant profit margin.
3) A gap down in price, in the context of an uptrend is a VERY high odds buying opportunity.
4) A gap down in price, in the context of a downtrend is a lower odds buying opportunity and may in some cases be a shorting opportunity when there is a significant profit margin.

While there is much more on gaps than one can write about in a short piece such as this one, keep in mind that the picture of the ultimate supply and demand imbalance is a gap. When you are ready to take a trade, simply ask yourself "who is on the other side of my trade?" and make sure you are trading with someone who is making a big mistake according to the laws of supply and demand, motion into mass, or whatever version of this basic governing dynamic you want to call it. Instead of looking at red and green candles on a chart and following a conventional Technical Analysis book, start looking a little deeper and begin to understand the order flow that is responsible for the creation of those candles. These basic thoughts will likely give you an edge over those who are on the other side of your trades and having that edge is the key to trading anything. If you are tired of transferring your account into someone else’s, stop looking at the market the same way everyone else does.

Have a great day.

- Sam Seiden