Artificial gaps

Artificial gaps occur when everything about the stock is status quo: The volume is average, the price patterns are inconsequential, and the fundamentals are the same as the day before. Many stocks have an artificial gap up or down in the morning because market makers are moving the price in conjunction with what the S&P futures are doing, and because of smaller order flow. Usually, when the S&P futures have a large gap up or down opening, they pull back or bounce to fill in the gap partially or completely. Many S&P traders like to fade this sort of gap opening, counting on an early morning pullback.

As a day trader, you can take advantage of artificial gaps by fading them like the market makers do. When fading artificial gaps, it is imperative to keep your eye on the opening price signal. Artificial gaps occur mostly with a mark up or down in the S&P futures in the morning. If the morning markup is overdone short-term, then you will receive that confirmation with the direction of your opening price signal within the first 15 minutes of trading. If a stock gaps up on an artificial markup, it will usually pull back to below the price where it opened within the first 15 minutes of trading.

You can take advantage of an artificial markup by shorting the stock when the opening price signal turns negative. You can also go long artificial markdowns by buying the stock when the opening price signal turns positive. This is a short-term trading tactic that is used to take advantage of volatility in the early morning.

Many software packages today have data displays that list the ten leading stocks that have gapped up and gapped down on the NYSE and the NASDAQ markets. The gap listings can be displayed in terms of absolute points or in percentage terms. Both are worth looking at, but the gap movement in terms of points is more effective for day traders. A stock that is low-priced could be listed as one of the highest gap openings in terms of percentage if it has gapped up small in terms of fractions. The largest gap-up and gap-down listing can be used to produce trading ideas.

gap-up short

When a stock gaps up in the morning more than 1 point above its previous session's close with no important news pumping it as a catalyst, it may be a shorting opportunity. There are five facets to monitor to determine whether the gap-up is real or artificial. The five facets to monitor are volume, price resistance or support, time, the opening price, and the AX.

As discussed earlier, artificial gaps have a tendency to be shortlived and are often the highs of the trading day. Gap-ups that are valid are the product of large institutional buyers. Positive fundamental news or important breakouts through technical resistance usually signify breakaway gaps that are not artificial.

If a stock gaps up and then sells off and remains beneath its opening price after the morning pullback has stabilized, it's possible that the stock has reached its high of the day. However, if a stock gaps up and pulls back during the morning pullback, but then ral-

lies to break above its opening price, the markup was probably not artificial and the stock should make new intraday highs.

Monitoring time, especially the first half-hour of the trading day, is tricky. Specialists on the New York Stock Exchange and market makers on NASDAQ make a good part of their profits during market openings. Many stocks pull back after a gap-up within the first 15 minutes of trading. This is because, after the initial exuberance, the smaller nonprofessional orders and the panic short covers are flushed out.

Refrain from shorting a gap-up on the opening bell. Wait for at least 5 minutes, until the market flushes out the nonprofessional buy orders and the panic short covers. When this period of time has elapsed, you'll have a clearer picture of what kind of order flow has caused the initial markup. After the first 5 minutes have elapsed, wait for a negative opening price signal (see Chapter 5) to provide you with short-term confirmation that the markup was artificial and that the short-term trend is pointing downward. Remember shorting an artificial gap up is an aggressive trading tactic, employed to capture the contra-move associated with markups on the opening.

After the first 5 minutes of trading, if the opening price signal turns from a positive signal to a negative one by at least 1/4 point, this is the go-ahead to go short, using a tight stop-loss point. The reason a buffer of 1 /4 point is used for confirmation of the opening price signal is that trading with the opening price signal is not an exact science.

The best spot to place your stop-loss on the short is 1 /8 point above the high of the day. If you are trading a volatile stock, use two areas to place protective stops when shorting an artificial markup. The first is 1/4 point above the opening price, for half of your short position; the second stop is 1/8 point above the high of the day. Traders who want to fade gap-up openings on Internet stocks should adhere to 1/4 point above or below the opening price as the first stop-loss point. Internet stocks often swing around wildly on an opening markup, so it is prudent to provide yourself with additional leeway by picking two spots for a scaled stop-loss.

A common fault of amateurs and professionals alike is impatience when it comes to putting on a position when the market opens. Order flow is all over the place in the first minutes of the opening, and market makers are often trading defensively, negotiating to unload unwanted positions and get orders off their desks as soon as possible.

Depending on the market-making firm, each market maker might have as few as 10 or more than 100 stocks that he and an assistant are responsible for trading. During a busy opening, a market maker and his assistant have their hands full with market orders emanating from various sources, including buy-side institutions, retail brokers, agency orders, the Internet, option firms, internal orders, and other broker-dealers. This early morning order flow causes choppiness, volatility, an undefined trend, and small inefficiencies in price. Don't let these false movements lure you into believing that something is happening when it really isn't. Choose to trade when the timing is working in your favor, not against you.

It is important to watch the volume carefully, when determining if a gap is valid. If a stock has gapped up high, ask yourself what kind of volume is printing on the tape at these levels? Does the volume warrant a move in price this high? If a stock has gapped up high, institutional block prints should hit the tape to confirm that the move is real. If institutional block prints do hit the tape and the price of the stock remains above its opening price after the early morning pullback, which usually occurs within the first 15 to 30 minutes of trading, it is an excellent sign that the stock has further to go on the upside.

On the other hand, if the stock has gapped up high but then slips beneath its opening price with no large prints hitting the tape, chances are that the markup was artificial, with the institutional players on the sidelines, waiting and watching.

During a gap-up it is important to keep your eye on the AX of the previous day to see if he is accumulating stock on the bid. Depending on the liquidity of the stock, it could take institutions with large orders several days to buy all the stock they intend to. These institutions normally give the order back to the same market maker until the order is complete.

If the stock was strong on the previous day and you identified the market maker who traded most of the volume, that market maker was the AX for that day. If that same market maker is back the next morning accumulating stock on the bid after it has gapped up, it is possible that the institution has given the market maker more stock to buy.

One of the best risk-reward trades available for a day trader during a gap-up situation occurs when a large institution takes advantage of an artificial markup to sell a large chunk of stock on the opening bell to the market maker. Market makers dread this situation, but are nonetheless placed at risk this way at one point or another. This happens when a stock is marked up and an institution offers a large block of stock to the market maker within a 5-minute window before or after the market opens.

Market makers advertise themselves as large buyers or sellers pre-opening in their largest and most active stocks. They do this through the electronic medium of Autex, Bridge, and the FIX for natural customer merchandise. When a stock gaps in the morning, the market maker often has to determine which side he wants to advertise on pre-opening. The market maker's objective is to identify the side where he thinks the institutional interest will be the greatest, and to take the opposite side in order to get the order.

If the market maker thinks that the stock will be better to buy, he will advertise himself as a seller. If he thinks that the stock will be better for sale, then he will advertise himself as a buyer. This is a risky way of capturing order flow, because it forces the market maker to take the opposite side of the short-term trend. If he mis-prices the merchandise, or if he is wrong in his evaluation of the trend, then he will lose money quickly. When the market maker is caught on the wrong side of the market on an artificial gap, the gap closes very quickly.

AMAT opened up 2 7/2 at 642/s bid, with the S&P futures trading 10 handles above fair value. A market maker who trades AMAT wanted to get involved. He had buyers the day before and he believed that the stock would be better for sale, so he advertised himself as a buyer on Autex pre-opening. An institution called his firm with a large order., "Dan, I see that you're out as a large buyer of AMAT this morning. I'll sell you 250,000 shares at 64 to work 500,000 behind it."

The market maker is now going to be long 250,000 shares ofAMAT, regardless of the final price that is negotiated. The market maker countered with a 637/s bid for the 250,000 shares, and the institution sold it to him. After the print hit the tape at 637/s, the bids faded, and AM AT sold off 1 in a hurry, to 627/s. The market maker was able to sell 100,000 shares to the street along the way, but still ended up with a large loss.

If a sizable print hits the tape after a gap-up and the stock immediately comes under selling pressure, chances are that this print was a seller. If a large print hits the tape in a gap-up situation and the stock runs higher, then chances are that it was a buyer—probably the reason for the gap-up in the first place. The market maker will support the stock if he has the buyer, or he will sell stock in a hurry if he has the seller. Institutions do not generally chase stocks in the direction of the gap in the early morning unless there is a fundamental reason for doing so.

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