My Favorite Strategies For Gaps Up And Gaps Down

Over the past 10 years, I have been on a search for the most important characteristics of winning and losing stocks.

During that time, I have found several different kinds of setups, breakouts and breakdowns that work for me. I love cups and handles, flat bases and base-on-top-of-base formations for the longs. For the sells, breakdowns off of flat bases or stocks that wedge up after drops work well.

But my absolute favorites are stocks that gap up or gap down. I believe it is the most significant sign of accumulation or distribution. A gap occurs when a stock opens significantly higher or lower than the previous day. It shows up as a gap on a price chart.

I am only interested in those stocks that gap because of an earnings report. I give no weight to stocks that gap on a brokerage recommendation. Earnings are the driving force behind stocks, so that is where I focus. The studies I have done amaze me because of the success occasions for stocks that have gapped up. The larger the gap, the better.

Gaps Up

I believe the reason for sometimes seeing the better action after a gap up in price is that once the earnings come out, analysts raise their estimates, not only for that quarter but usually for the following quarters. Institutional money may pour in on that day. Investors will not buy after a stock is up a large number on the open, just like many investors don't like buying when a stock makes a new high. I believe this gives the smart investor a chance. I have found that stocks that have gapped up, have held up better in a bad market. In a good market, they have often gone on their way very quickly.

I would be careful about buying stocks that gap up after a big run. They have been prone to failure at the end of the big move. If you are fortunate enough to find a gap right at a breakout point, I believe the potential for success is higher.

Here are several examples.

Notice, I did not list any stocks from the year 2000. Good reason. There weren't many. When hardly any stocks are gapping up, it may tell you about the market.

Gaps Down

On the other end of the spectrum, and probably more important than stocks gapping up, is the gap down. I say this because protecting principle is sometimes more important than making money. Just look at the year 2000. After I read about stocks gapping up, I decided to find out if the opposite was true about stocks gapping down. The results of my studies were amazing. Simply put, when a stock gaps down on a worsening earnings outlook, the best thing to do may be to get out of the way. There is no one magic bullet to investing. But if there is one technical characteristic that could work consistently, it is the gap down.

You must understand that there are several things potentially at work when a stock does gap down.

1) Something fundamental may have changed at the company. Wall Street tends immediately to react to this. It is not easy for companies to bounce back from a bad quarter. In fact, I believe in the "cockroach effect." Usually one bad quarter leads to another.

2) The way Wall Street looks at the stock may have changed. Often the company loses credibility. Investors, analysts as well as institutions become afraid to touch damaged merchandise.

3) Most important is the word reality. I have looked at thousands of stocks over many market cycles. Stock price action is not one person's opinion. It is the interaction of all. One best not fight this action. The fact is that ignoring a gap down could be fatal to an investor that does not recognize it for what it is. But don't take my word for it. Do what I did. Start your own study. I believe you will be amazed.

Here are just a sampling from the year 2000.There were many more. A great clue to how bad the market was going to get was to watch how many stocks did, in fact, gap down.