Let's get started on Part 2 of How to Predict Market Action From the 1st Hour of Trading by discussing the Heavy Market Gap-Ups.
You'll remember yesterday how I discussed gap-downs can be very difficult for the bears to hold on to the weakness. So the obvious conclusion then is that bulls would have a difficult job of holding on to gap-ups. But that comparison really doesn't work with gap-ups. They are completely different in personality and how the market responds to them.
There are a lot of major players in the market with tons of buying power that simply cannot short the market or any stock for that matter. As a result, the only choice they have is to buy or sell (short/cover isn't a viable option).
These same entities (like mutual funds & some hedge funds to name a few), in order to remain relevant, need to BEAT the S&P (assuming most use that as their benchmark that they are measured against) or AT LEAST match the S&P 500 returns.
Therefore when the market gaps up and if they aren't fully capitalized… guess what they are going to do? That's right… They are going to CHASE the S&P which thereby leads to additional buying.
So let's further examine this market condition and what you can learn from it.
- + Strong Gap-Ups are much harder to reverse to the downside than Gap downs are to the upside. Why?
- + Strong gap-up is typically of more than 1.0%
- + Funds of all types see the gap-up and make emotional decisions to chase the market throughout the day. Those who wait are eventually sucked in at some point in fear of missing a larger move and justify their buying with the belief the market rally could be multi-day.
- + Most traders and investors are long-types only, so like the funds, they are prone to chase, even though they may not be forced to meet S&P 500 benchmarks, there is still the fear of 'missing-out'. Adding additional buying power.
- + With all this additional buying power, there are plenty out there who will use the gap up and the strength that it provides to sell out of some of their existing positions, but most times, the buying power coming from the chasers will keep the market trading in at least a sideways channel.
- + Usually these gap-ups can be rather boring days for traders, as they will have a lot of their 'trigger-prices' nullified by the stocks gapping through them.
- + A particular scenario where the aforementioned does not apply is typically in bear markets in a well-defined downtrend – where bears have full control of the market, very confident, and are specifically LOOKING for gap-ups and early morning rallies to short the dickens out of. In these cases, what BULLS are looking for any pop to get out of their existing positions which adds to renewed selling despite the gap-up.
The Result: There are times as well when the market will flounder after tha gap up, possibly even fill the gap and bounce right back, and not sell-off per se, but those instances don't happen nearly as much. The chances that a strong gap-up stays a strong gap and consolidates or even builds upon its opening price is about 65% likelihood. Chances of a complete reversal and ending lower is 15%, and the chances of it floundering somewhere above breakeven and the opening price is around 20%
By the way folks, it's important to remember that ultimately the market does whatever it rightfully wants to do. What I'm providing you with in this series is not some fail-safe mechanism to trading but a navigational tool for trading these financial markets.