How To Trade A Bearish Gap - The Swing Gap Down Trading Strategy

A bearish gap is when a stock opens lower than the previous close by a wide margin. This kind of gap can present short sellers with an amazing opportunity to short the stock. Stocks often fall 3 times faster than they rise and a gap down can often ignite a massive move down in the coming days, weeks and months. In this article I will show you what a bearish gap looks like and how you can take advantage of this pattern to make money in the markets.

What A Bearish Gap Looks Like

A bearish gap looks like the prices just opened way lower than the previous close with no trading in between them. There will be a white space or a void.

bearish gap down

The chart of SLB above shows how a bearish gap looks like. The stock was trading sideways and then one day it opened way lower than the previous close leaving a void or white space where no trading happened during regular hours. You can see the effect of the bearish gap. SLB moved lower from there and at the time of this writing it has moved from around $74 to $67 in a very short period of time. Those who shorted this stock as it gap down would be making some nice profits.

How To Short A Bearish Gap

This strategy that I'm teaching you will be a "short the bearish gap using daily charts". Therefore, once you short the stock you can sleep tight and wait for the trade to work out in a few days time to a few weeks. You do not need to stare at the computer screen all day and you can accomplish your goals without the stress of day trading.

There are lots of day traders who trade gaps and close it within the trading day. But if you use this trading strategy, you can short the gap and still profit from it without looking at the screen the whole day. Because the holding period is more like a swing trade type of period, I called this gap down strategy the Swing Gap Down Trading Strategy.

The above is how a bearish gap looks like. AT&T had 2 bearish gaps that gave traders an opportunity to short the stock. This is how you generally enter the trade:

  1. You short the stock the moment it gaps down
  2. You put a stop at the high of the previous day's bar

While putting a stop loss so far above might lower your reward to risk ratio, it gives you lots of protection in the case of a fast snap up. You will see in later charts how a gap down can often give you a good enough reward to risk ratio even if the stop loss is far away. That's because bearish gap down can often make a stock lose 10%, 20% and even 50% of its value in a short period of time.

The first thing you want to look out for of course is a gap down. Now, how do you spot a gap down?

freestockcharts screenerThe freestockcharts.com screener I use

You can use a stock screener from your stock chart provider or your broker and scan for stocks that have large negative % changes. Usually a negative pre market change of 1.5% and more will result in a gap down. It is good to be able to have pre market data but sometimes it is not necessary. You want to have a screener that you can scroll through with the charts loading up next to the screener so that you can see how the bearish gap looks like in the big picture.

You want to ask questions like, is the stock gapping down below support or gapping down below an uptrendline etc etc. We will go into that later.

For now, let's take a look at some other charts to see how the bearish gap down works.

Additional Criterias And Helpful Tips

Now that you have seen some charts of bearish gaps, I would like to show you how to find some of the best bearish gaps to play. Not all stocks that gap down are good for a short. If you short every stock that gaps down, you will be very surprise to see some of those stocks moving back up just as fast as it went down. Then when it hits your stop loss, you will be extremely frustrated.

What you want to be looking for is this:

A Gap Down Of Weakness

That means the very fact that it gaps down will make the stock even weaker. The direction of the stock in the next few days to weeks is down as the result of the bearish gap down.

How do you spot a gap down of weakness? Here are some things to look out for:

  1. The stock gaps down below a support area
  2. The stock gaps down below an uptrendline
  3. The stock is in the process of forming a bearish chart pattern when it gaps down (ex. double top, descending triangle)
  4. The stock is in a downtrend
  5. The stock is in the red zone (below 20 MA and 50 MA)

When a stock experience a bearish gap in one of the above situations, the bearish gap will most likely cause the stock to move even lower. These are the gap down that you want to focus on. Just because a stock gaps down, it does not mean you should short it. You have to consider the overall big picture.

Bearish Gap In Red Zone

The bearish gap in red zone simply means that the gap down happen when the stock is in the red zone. The red zone is where the stock is below its 20 MA and 50 MA. I shaded the area below the 20 MA pink and the area below the 50 MA red. So, when a stock is below its 20 MA and 50 MA, it will be in the red zone. To learn more about the red zone please read How To Avoid Huge Losses In Stocks And Maximize Profits Using One Simple Stock Market Trick.

A stock that is in the red zone is in a bearish zone and it is not suitable to be bought. On the flip side, it means that the stock is suitable to be shorted.

In the chart above, you can see how PAA was in the red zone (below 20 MA and 50 MA) for a long time before it gap down. The stock was actually starting a new downtrend and when the gap down happened, it was a gap down that further weakened the stock. The stock was also gapping below a support area.

The combination of these factors made it very conducive to short the gap down. Look how PAA fell. From around $29.50 it fell to $23.68. It lost about 20% of its price after the bearish gap down happened.

Bearish Gap Below Support Area

A stock that breaks support is bearish. That is why you often see a stock collapse very fast when it breaks a support line. When a stock gaps down below a support area, it is even more bearish. That means traders were expecting it to fall and at the open, everyone is already bearish on the stock.

In the chart above, you can see how WLL broke below a support by gapping down. When a stock gaps down below support it is bearish and you can short it immediately right at the open or shortly after the opening bell. There were a few things that made WLL bearish. First is it is in the red zone and second it broke a support line. So that is why the stock fell from around $7.50 to $5.65.

Bearish Gap After Breaking An Uptrendline

Trendlines are very powerful indications of who is taking control of the stock. A stock that stays above a trendline is controlled by the bulls. On the other hand, when the stock breaks an uptrendline, it means that the bears are coming in and they are winning the battle. The tide of the battle turns when a stock breaks an uptrendline. It signals weakness and you should definitely look for signs of a bearish move in the stock.

ABX, broke an uptrendline recently in April 2017. It traded sideways for a few days but it suddenly experienced a gap down. When the stock gap down, you can short the stock at the open. A bearish gap down after a stock breaks an uptrendline will often send the stock lower. Look how fast ABX fell within 2 weeks.

At the time of this writing, this stock just experienced another bearish gap down and broke a support line. The stock is likely to go down further and my target will be around 14.00 to 14.30. Which is where the next support area is. Of course, one should also put a stop loss on this one. The stop loss for this short will be the high of the previous bar.

When To Exit The Trade

Now that you know how to find good shorting candidates for bearish gaps, you also need to know how to manage the trade. We want to know how to enter, how to manage it and how to exit the trade. Without a plan, even the best entry will become losses.

Here are some things to consider to exit the trade:

  1. Support areas
  2. Use a shorter time frame trend following method
  3. Use oscillators like stochastics and MACD 

Support Areas

If you are shorting a stock and you see an area where there is a lot of price congestion, you better exit the trade immediately. That's because the odds are very high that the stock will stop going down in that area. So, if the stock you short has lots of voids below and you see a support very far below, you can have confidence to hold the position for a bit longer.

For those of you who are not familiar with support and resistance you might want to read about it by clicking on the link.

A Simple Trend Following System In Lower Time Frames

Since we are trading the bearish gap using the daily charts, you might want to use a trend following system in the 60 min charts to help you catch the majority of the bearish move. You won't be able to catch 100% of the move. But at least you can get about 70% to 85% of the move and that is already very good.

Once you have shorted the stock, you might want to consider covering the short when the stock trades above the 60 min 50 MA.

The chart above shows how ALXN had a nice bearish downtrend. It was in the red zone most of the time until June 1 2017. That was when it went above the 60 min 20 MA and 50 MA. To short sellers, it was time to cover this stock and take profits. You can also use this simple trend following tool to help you capture the majority of the profits in your short positions.

Using Oscillators

Some stocks that gap down may not have a nice downtrend after the gap. What might happen is that they have a step by step downtrend and that can be frustrating to traders who are making a nice profit. You are making some nice profit and the stock bounces up and the profits are all gone. Just when you have covered the position, the stock goes down again and you wish you had not covered the short. It can be frustrating at times. 

So what do you do?

If you sense that the stock is the type that goes down step by step and not the smooth nice downtrend ones, then you can use the stochastics or the MACD.

Once you have shorted the gap down, look at the stochastics and see if it has a smooth buy signal with smooth lines emerging. The smoothness of the stochastics signal looks like two lines about to make a nice railroad track. Once you see that, you might want to cover your positions.

The chart above is the same chart of ORLY but with the MACD lines. You can cover the position when the lines look like they are about to U-turn and go up. When there is a MACD line cross, you should definitely be out of the position.

Conclusion

You have now learned a new trading strategy utilizing the bearish gap. You have also learned how to find the best bearish gaps, how to enter it, how to manage the trade and how to take profits. The bearish gap trading strategy offers you the opportunity to take advantage of a fall in stocks and reap a nice risk reward. Study more gap downs and come up with your own annotations and refine the education in this page. You will soon be able to capture profits in the stock market using this bearish gap down trading strategy.

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