Market Open 101
So, why do we see such large changes in prices as the market opens?
Well, while the markets may be officially closed, the trading itself doesn’t really stop. Many traders will place buy or sell orders when the market is closed to profit from the perceived formation of an opening gap at the start of a day’s trading – circled in the graph below
Candlestick charts, like the one shown below, allow us to see the gaps forming clearly.
Each candlestick represents a period of time and the movements in price that went on during that time. The thicker red or green ‘body’ shows the opening and closing prices, and the thinner ‘wicks’ of the candles shows the highest or lowest prices during that period.
A candle will be green when it closes above its opening price, and red when it closes below its opening price so you can easily tell if there was more selling or buying during the period.
An opening gap forms as a result of excess buying or selling of a stock after the markets are closed. Newsworthy events that cause a large change in investor sentiment after trading hours are often to blame for a large increase in buying/selling activity that occurs in the morning as markets open.
It helps to think of this as a massive backlog of orders that pile up overnight and then flood through the door as the markets open, forcing prices to adjust quickly to reflect the excess demand that has built up overnight.
Be warned, however, low liquidity during off-peak hours can be very dangerous, causing erratic price changes that can be very costly if you get caught on the wrong side of a gap.
So, what’s the best way to handle these gaps? At the end of the day it’s all about your risk appetite.
The best way is to stay on top of the news to preempt any overnight activity that may affect your investments. If you are worried that a future event may affect your positions negatively, then perhaps closing your position and reopening it once the dust has settled is a safe way to manage your risk.
Alternatively, if you are confident that an overnight event will drive a price in a certain direction then you can enter overnight to capture the profit from that large opening gap, but the cost of being wrong could be sizeable.
Experienced traders will look to exploit gaps for short-term profit, but this is highly risky. A gap on a chart is often filled or partially filled as markets adjust to a large event and find a more stable middle-ground. So, if a stock has just gapped up by 2% after the open, some traders will often open a position in the opposite direction (sell) to capture the short-term decrease in price that results to fill the gap – as seen below.
However, gaps are not always filled and trading opposite to the gap can cause big losses if your prediction fails – so watch out!
A safer strategy is to use the first market movement as an indicator for the direction of the rest of the day’s trading once the market has adjusted to the early movement and chosen a direction, which you then follow. Remember, investing is about the long-term, so don’t let day-to-day upsets throw you in or out of positions, but always follow the news so you’re aware of large fundamental market changes.