In a perfect world, price gaps would be eradicated and liquidity would reign supreme. The movement of an asset would be a continuous stream allowing easy entry and exit. Picture an uninterrupted flow that allows all participants regardless of size the ability to buy and sell at any darn price they please. Slippage would only crop up when you run too fast to the bank and encounter a well-placed banana peel.

Sadly, such an idealistic realm only exists in theory. In the real world, the equities and options markets are only open for 6.5 hours a day. And when overnight imbalances arise in supply and demand, traders have to grapple with a gap the next morning. Like last Tuesday for example. The S&P 500 opened about 0.6% lower which is a decent sized down move these days.

Now, suppose you had a bullish option spread on Baidu Inc (BIDU) and planned to bail on a break of the $216 support level.

On Tuesday BIDU opened at $216 and promptly fell to $213.53 in the first minute of trading. It bottomed within one minute of opening and powered higher the rest of the day closing at $220.66. Had you kept your stop loss in place you would have been stopped out at the open, only to see BIDU recover without you.

How insulting!

This is why I’ve adopted a gap tactic to prevent such annoying whipsaw. The reality is many down gaps open near the low of the day making the exit of bullish trades at the open a bad idea. So here’s what I do. Anytime a stock is gapping below my planned exit threshold; I remove any standing stop loss orders I may have. Then, once the stock opens I let it trade for at least 5 minutes and perhaps as long as 15 minutes. In the case of the 5-minute rule, I will simply have a 5-minute chart open and wait until the first candle has formed. Then, I mark the low of that candle and use it as the new stop loss. If later in the day that level is broken, then I assume the attempt at filling the gap has failed, and the support break was the real deal. Thus, I exit!

Here’s what the 5-minute chart looked like for BIDU on the day of the gap:

Now, because of the large size of the first 5-minute candle, you may have been uncomfortable moving the stop from the original $216 all the way to $213.50. In that case, I drill down to an even smaller time frame (1-minute) to see if there’s another level that makes sense.  Here’s what that technique would have looked like:

In this instance, I elected to place the new stop at $215 since the $213.50 level was simply too far away. If BIDU were to rollover again, I wouldn’t need to wait until we dropped all the way to $213.50 before realizing the bounce attempt failed.

This technique also works when you have bearish trades on during a large up-gap. Only instead of placing the stop at the bottom of the first 5-minute or 15-minute candle, you would put it at the top. Take a look at TLT or GLD last Tuesday to see what I mean. They both jumped considerably higher, opened at the high of the day, and promptly fell from there. Getting stopped out of bearish trades in either one at the opening bell would have been supremely annoying since they proceeded to bite the dust all day long.

Keep this tactic in your back pocket for the next time a pesky price gap crops up.

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