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THE MARKET WHISPERER 31 7
Why Do Gaps Form?
Generally, a gap already forms at the pre-market stage, because buyers are
willing to pay a higher price for the stock than the previous day’s closing
price, or sell for a lower price than the previous day’s closing price. The
pre-market open price is set by the market makers in accordance with
supply and demand, as conveyed to them several hours prior to trading.
When demand is greater than supply, the stock will gap up; when supply is
greater than demand, the stock will gap down. As we will learn, stocks are
also traded during pre-market hours!
Why Do Gaps Close?
The explanation begins with the previous day’s trading, where an
institutional buyer received instructions to sell a large quantity of shares
(in the current example, BAX).
Firstly, we need to keep in mind that institutional traders buy or sell
large quantities of shares and therefore scatter their sell orders across
several days so as not to adversely affect the stock price. Their goal, of
course, is to sell at the highest price possible, since if they do so (relative
to the stock’s behavior on that particular day: see the section on VWAP),
they receive handsome bonuses.
Let us assume that the institutional trader who sold BAX on the first
day of trade has not yet completed his or her task, and still holds several
hundred thousand shares which must be sold the following day. At the
start of the next day, the trader tries to complete the task and sell more
shares.
Keep in mind that the trader was willing to dispose of them for yesterday’s
close of $47.27 [1]. To his or her great joy, the second day of trading opens
and the trader finds that buyers are willing to pay $47.61 [2], some 0.8%
more than the previous day’s closing price! For the institutional trader, this
is a gift sent from heaven! The trader knows that if he or she sells for more
than the previous day’s close, a fine bonus awaits. What does the trader
do? Rub his or her hands with glee and sells! How far down will the trader
sell? For as long as the price remains above yesterday’s closing price: in
other words, for as long as he or she can earn a bonus! Institutional traders
do not rush. They know they have the ability to flood the market, but they
do not want to see sellers changing market direction too quickly. So they
sell a little, wait until buyers return, sell a little more, and so on. We need
to keep in mind that the institutional sellers are also competing with other
