On June 4th we posted a pre-market video in which I discussed a potential “gap fill” trade in TIBX. When a stock gaps outside of the prior day’s range you have three options. Play it for a continuation in the direction of the gap, play it to fill some or all of the gap, or simply take a pass on trading it.  I have found over the years that most traders consistently choose the same option each time disregarding many factors that favor choosing one option over another. Why is this the case? For many it is a lack of methodology for trading gaps. For others it may be they are just more comfortable fading stocks versus following the trend. And finally some traders simply prefer being short over long or vice versa.

Whatever the reason is for the lack of differentiation one thing is clear. Most traders aren’t making optimal risk/reward decisions. Imagine if Tony Parker were guarding Lebron James. Do you think he is more likely to take a 3 point shot or post up close to the basket? Or if Hibbert was guarding James do you think he is likely to post him up or move to the perimeter? Now of course LBJ has the skills to drive, post up or take a 3 pointer depending on which shot makes the most sense, so a trader must understand the difference on managing a short trade versus a long, but if they have that skill then they are doing themselves a disservice by not taking the trade with the best risk/reward for a given scenario. And if they don’t possess the requisite skill perhaps they should consider spending more time working on their game?

Here are some of the things one should consider before trading a gap:

• Has a trend been established prior to the start of the regular trading session
• Has the stock recently moved higher/lower a large percentage
• What type of catalyst is causing the gap: Earnings, Market, Sector, Governmental Action
• What type of “market regime” currently exists
• How heavy was trading volume before the market has opened
• What have stocks with similar types of catalysts done recently

In the case of TIBX there were several factors that caused me to play it from the long side:

• It had already been a longer term down trend prior to the release of earnings which seemed to be pricing in decelerating earnings
• It had recently attempted to bounce and therefore had a clearly established floor to trade against and to judge whether this gap would be used as a buying opportunity by those who had missed the bounce prior to the earning’s release
• A benign environment for technology stocks under which bad news is bought unless the stock has recently made a large move to the upside

So my initial assessment was TIBX was a good bounce candidate. Next steps were evaluating its price action following its earnings release. As you can see from the first chart below after a huge gap lower TIBX bounced around $1.50 in the after hours. The next morning buyers stepped in again at 8AM when pre-market volume generally picks up establishing a clear uptrend. The only remaining price action I would need to see for final confirmation of my long thesis would be an initial opening drive above the after hours and pre-market resistance. Once I see that my mindset should be that the odds are heavily stacked in favor of an uptrend for they day, and possible swing trade back to recent highs.

The second chart gives you a better big picture view and the upside potential that played out the following week. It also illustrates why I love the idea of developing intra-day trading skills to greatly enhance the risk/reward for swing trades.

Steven Spencer is the co-founder of SMB Capital and SMB University which provides trading education in stocks, options, forex and futures. He has traded professionally for 18 years. His email address is: [email protected].

Steven Spencer is currently long AAPL, CROX, FB, FRAN, GM, GMCR, HTZ, IWM, MU, WAVX, XOOM and short GTIV, KKD, KO, OPEN and ZQK.

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