Price gaps are very important to any investor because they can signal a critical change instock's direction. Gaps occur when a stock trades up or down in price during after hours trading or in pre market trading. Understand how to interpret the gap and you can have a distinct advantage for the long term outlook of the stock.
How a Price Gap is Created
A price gap is created when a stock closes at $xxx for the day which is at 4:00 PM EST, then in after hours or pre hours trading the following morning is bought up or down in price. With the buying or selling during this time when the market is technically closed, the stock then opens up at 9:30 AM EST up or down right off the bat. When you look at the chart of this stock there will be a gap in the daily bars, which means a price gap has been created.
Let's take an example with most recently Apple (AAPL, Charts). The stock closed on 10/22/07 at $174.36, then reported earnings which they blew out. It was then during after hours trading, which again is trading while the market is technically closed, traded up in price all the way to above $188. So, the next morning at the 9:30 AM EST opening bell that is where AAPL stock opened in price. You can see this price gap range in the chart below of Apple,
Price Gaps Help Determine Future Price Movement
A price gap up or down in price can actually be a determination of the overall direction the stock will move in the coming months. A big price gap on very high volume, which means strong institutional buying of the stock, could mean more higher prices to come.
You will develop over time an understanding of what different sized price gaps mean in different situations. For example Apple had a price gap way back in April of this year on very strong volume, and the stock closed that day at $98.84. Now several months later as you saw above the stock is trading above $180 a share. Beware though, if a price gap comes too late in a stock's run it may actually be a sell signal. Like anything, after watching 100 price gaps occur of all different shapes and sizes you will inherit a "6th sense" of where the stock will move in the coming weeks and months.
More Examples of Price Gaps
Just to help you visually see price gaps on stock charts, here are some more examples of price gaps from the past year. Notice how the price gaps are of all shapes and sizes.
Amazon.com (AMZN, Charts) started its huge run this year with a price gap, and has had several more since. The first came on April 14th with the stock finishing the day at $45.20. The most recent was a negative price gap where the stock gapped down in price. This came after earnings and the gap occurred on 10/24/07.
Google (GOOG, Charts) has had a great run this year and too has had several price gaps both positive and negative with the stock now trading above $670 a share. The first you will see is actually a gap down in price which came in July, but notice how the stock held up in price and two months later started to move back up. Since September there have been several price gaps, and to keep things simple I am only going to show the most obvious ones.
Sears Holdings (SHLD, Charts) is an example of movement to the downside after a stock price gaps. The stock's first came in early May and finished the day at $179.76. Since then it had a major negative price gap again in July and several others both up and down. SHLD is now trading just below $140 a share.
The most common reasons price gaps occur is because of earnings and acquisitions. The bigger the price gap, the bigger the reasoning behind it.
If you look at price gaps as a means of judging value, you will find they are fairly easy to interpret. Any major event that really changes the value of a stock today or in the future will ultimately affect the stock price.
The Bottom Line
Stock price gaps are caused by after hours or pre hours trading when the stock market is closed. The stock trades up or down in price during these times, and at the opening bell the following morning opens at that most recent price.
Gaps occur in all different shapes and sizes and can be a means of predicting the price movement of a stock over the next several months. Not all gaps tell the same story though, so it is important to conduct your own research before assuming anything.
Some of the biggest price gainers in 2007 have started their runs with price gaps to the upside. The more you view price gaps the better you will be at interpreting their true value. Sometimes the "how big" is more important than the "why". Then again, it could be opposite, but that's for you to figure out .