Any time a stock gaps down, it serves notice to the market.
No matter the magnitude, a gap down in share price warns of an abundance of sellers. Often, those sellers will stick around and the stock will continue falling. Other times, however, the selling is temporary and the stock can get on with its life.
Here's how to tell the difference from survivable gap downs from the outright pernicious ones.
First, let's make sure what a gap down is: It's when a stock trades an entire day in a price range below the prior session's low. The "gap" from the prior day's low to the high of the next day tells investors that market makers and specialists on the stock exchanges had to bring the share price low enough to draw enough buyers.
These characteristics tell you the gap down is more severe: • The gap comes in heavy , a sign of intense institutional selling.
• It breaks a key support level, principally the 50-day average.
• It creates a sell signal, or sell signals are already in the chart; for example, a gap down that becomes the largest one-day loss since the start of the stock's major advance, or a significant loss in the heaviest volume since the stock's run.
• A gap down that forms within a base is not fatal, but needs to be evaluated carefully.
In 2011, a chart reader looking for these clues would have found reason to stay away from the LED maker Cree (CREE).
The stock worked on a base for many months but never broke out. Shares gapped down Jan. 19 to a 14% loss (1) in the highest volume in at least a year. (2)
Shares slid below the 50-day moving average and the nearby 200-day line. The combination of sell signals and the gap down accelerated a decline that would take Cree to a 75% plunge from the April 2010 peak of 83.38.
Today, Cree has recovered most of that drop since a December 2011 low of 20.25.
In 2010, Buffalo Wild Wings (BWLD) had made a recent new high when the stock gapped down on Oct. 27. (3) But the stock trimmed most of the day's loss. In a significant part of the move, Buffalo Wild Wings closed just above the 50-day line. (4)
Volume was heavy (5) but not on the level of earlier big-turnover days.
The restaurant chain simply went on to form a base. It broke out about three months later (6)and climbed 87% in 13 months.