Have you ever owned a stock that has exploded or sky rocketed in price overnight?

If you have, you are probably familiar with stock gaps - especially the kind that are news driven.

And if gap trading is something you do regularly, then you probably already know the dangers involved.  But do you know one of the safest ways to trade gaps?

Take a look at this.

There's no better way to understand the magnitude of a gap then to see a picture.

I remember this stock.  On Monday morning, May 4th, 1998, Entremed gaps up ... and I mean gaps up in a very big way.  This stock opens at $83.000.  Friday's close was at $12.063.  For those people lucky enough to be owners of this stock before May 4th, the stock offered a windfall profit in a very short time.

But noticed what happened.

Even though the stock opened up at $83.000, the stock closed at $51.813.

What happened?

Over the weekend, the company announced some "good" news.  I don't remember the particular details; but I'm sure it had something to do with getting approval, a new discovery, or something along those lines related to it's business. 

This is a classic example of a news driven gap.  For our purposes we only want to look at gaps that have the open greater than the previous high or less than the previous low. We are not interested in stocks that gap open from the previous close but open within the previous range.

And as so often happens, once the news is out, so is the price move.  Notice that the stock closed down for the day on May 4th relative to it's open.

Yes, it closed up from the previous close.  But for the trading day that took into account the news, the stock actually closed down.

Not only is this a news driven gap, it's also an exhaustion gap.

The news is out, the stock price move is over, finished, complete, done.

Here's where you come in.

On the day that ENMD gapped up above the previous day's high, the stock (1) closed less than the open and (2) did not trade into the previous day's range.

For the next day, as long as the stock behaves the same as the previous day (closes less than the open and does not trade into the day before yesterday's range), then you have an opportunity. 

(1) Sell short on the close of the second day:  There have been two consecutive down days (comparing the close to the open), the odds are the stock will continue down.

(2) Place a protective buy stop above the high of the sell short day.

In this case, notice that ENMD gapped down the next day.  Sharp traders could have easily made $10 per share in one day.  And for those brave enough to hold on to their short position, the stock gapped down again the following day.

It's easy to talk about how much money one could have made.  What's more important is how much money you were willing to actually risk.

Just because the stock closed down two days in a row doesn't mean it's going to do down the next day - the odds are it will though.

What if just the opposite happened?  What if instead of trading down after selling short, the stock gapped up - a breakaway gap to the upside?

That's why it's important to risk a very small percentage of your portfolio on any one trade.

On a trade like this, if you have a strong enough stomach - and the trading capital - you would want to trade much smaller than you normally do.

Another stock, another opportunity

Genesis Microchip had two big gap down days for 2002.  The first gap was a down day (close less than open) followed by an up day (close greater than the open).  When the gap day and the following day are not in the same direction, then no trade.

The next news gap had both days closing down.  The sell short opportunity allowed for a low risk opportunity that resulted in a more than 30% drop in price in a few weeks.

These type of opportunities are easy to find.  Stocks that move like these are usually in the news.  And just because these trading gaps examples are sell short opportunities doesn't mean this method is for short selling only.  The opportunity for profit when buying stocks is just as good.

Trade well!!!