One of the [intlink id=”2227″ type=”post”]stock picks[/intlink] I tipped yesterday gapped up and gained 13.30%! I thought of traders wondering how to trade Assured Guaranty Ltd (NYSE:AGO) stock when shares gained 1 dollar right on the market’s open! It’s easier to trade a stock that is trading at the support level than when the stock gaps up, since the stop loss needs to be adjusted in order to manage your capital more efficient. Most of the time, when the stock you are looking to trade long gaps up, you need to let go of that trade. That is because in case traders decide to trade the stock, they will either increase their risk damaging the reward-risk ratio, or set a stop loss at a wrong price level.
According to yesterday’s post, stock trading close at the support level was well justified, albeit quite risky since the stock has been trending downwards and identifying a breakout as a false one is always dangerous. Risk averse traders wouldn’t keep an eye on the AGO stock due to these facts, but risk seeking investors would find appropriate to buy stocks under these circumstances. Still, when the AGO stock opened yesterday with an enormous gap of 11%, I’m sure they were puzzled whether they should enter a trade or wait for a pullback. Of course it’s extremely rare to witness an intraday pullback after such a strong move. So…
How do we trade a stock pick that gaps up?
We simply don’t. There are numerous other stocks to search for promising [intlink id=”2211″ type=”post”]bullish candlestick patterns[/intlink]. But let’s say that we decided to trust the stock pick and invest in Assured Guaranty Ltd. Say we were quick enough and bought AGO shares 3 minutes after the open for $11 per share. We had already planned to set the stop loss at $9.00 or a couple of cents below that, since the stock price had found support there. If we traded on Wednesday’s close at $9.69, we would stand to lose 70c per share. Now the trader’s risk has increased substantially to 2 dollars per AGO share! Risking 2% of our trading capital would lead us to buy one third less shares now. For example, if we meant to risk $200 on this trade, we would buy 300 AGO shares on Wednesday but just 100 on Thursday according to the stop loss!
However buying at that gap would also mean less profit. On Wednesday the profit target at $14 was $4.3 up, giving us 6-1 reward-risk ratio. Now the profit target has decreased to 3 dollar per share and combined with the looser stop loss, the R-R ratio would be reduced to 1.5-1, four times less!
Another option would be to set the stop loss higher, neglecting the fact that the order will be set higher than the original support level. Traders can improve the reward-risk ratio in that way but they are hoping to get lucky, since the stop loss will be set somewhere inside the gap! It’s quite common the stock price to retrace filling the gap, before continuing in the gap’s direction. Thus the stop loss would be hit before traders can profit from their correct prediction.
When one of my stock picks gaps either up or down, I don’t trade that stock. It’s better to wait for another trading opportunity than increasing the risk and damaging the initial reward-risk ratio.