When a market gaps up out of a trading range it confounds many traders. They do not understand how the price can gap up to a whole new trading range, stay there all day, and even go higher through the day. If the gap is out of an oversold level it is actually a high probability trade entry in most cases as a new trading range is established with the potential of a new uptrend beginning. If a gap up does not fill in the first hour and a half of trading the odds are it will just keep going in that direction for the remainder of the day. Shorting momentum is a bad idea in most cases and shorting a gap up is not a signal in most cases it is an opinion. Gap ups tend to work much better in long term up trends than in bear markets.
What causes these situations? They are generally psychological and not based on fundamental valuation changes:
There are only three positions a trader can hold on a gap up day: Short the position, holding it long, or flat and in cash.
- The traders short positions will have a very strong desire to cover their shorts to stop the pain, this will increase as the day goes on. Shorts that have to cover due to being stopped out into the gap creates buying pressure pushing the market up yet farther.
- The traders and investors long have no pressure to sell on the gap up day. They are happy with their positions and generally let the winner ride in most cases. There is no pressure coming from long positions being stopped out so this alleviates a lot of selling pressure. Only profit taking from this group creates selling pressure and they are under no real urgent pressure as they see their account grow.
- Traders and investors on the side line in cash want in on any pull back. Professionals have under performance of the market as pressure and they need to chase and get positioned right so they have pressure to buy. Traders that are flat want to get on the profit bandwagon so they create even more buying pressure as they enter on any chance they get. Many will give up and chase by the end of the day as well.
This is what causes these types of gap and gos. Long are sitting tight creating no selling pressure, short are having to cover causing buying pressure, and people on the sidelines are wanting in causing dips to be bought and rallies out of weakness. Think about these dynamics next time you think “It just can’t go any higher.”