A story of two price gaps

Here are two charts of major UK stocks which have suffered well publicised gaps down recently.

The first is Tesco. Their gap down has been caused by a massive overstatement of their profits. As a trader, you would either have been out of this stock or short - the line of least resistance has been clearly to the downside before that news came out. As Paul Tudor Jones said "I always believe that prices move first and fundamentals come second".

The second example is a bit more tricky. This is Serco, who yesterday morning announced another profits warning and the launch of a rights issue. This led to a drop of more than 30% drop in the share price when the market opened.

The chart shows that price had started trending upwards over the last couple of weeks, and some people may have seen that short term strength, decided that the bottom was in, and decided to go long. 

However a closer inspection of the chart would have given you several warning signs. Apparently this is the fourth profits warning by the company this year, and a cursory look back at the chart for the whole year would have shown the price gaps caused by these announcements. 

Also, simply by zooming out on the chart you can get a longer-term 'feel' for the overall trend. I've purposefully shown only the last 6 months or so on these charts - I like to ensure that at least 9 months activity is shown on my charts. I also refer to a weekly chart open showing activity over the last 2-3 years, which shows the longer term price trends. Doing this would have shown a near 50% drop in the share price over the 12 months or so, prior to yesterday's announcement. Failing that, you may want to refer to a long-term moving average, such as the 200 day, which will give you a feel for the longer-term price action.

Next, if an earnings announcement or trading updated is expected in the next 1-2 weeks, I deliberately avoid taking a position in that stock. If I was trading from a longer-term perspective, then this would not be a consideration. As my approach is towards the shorter-term trends, then I need to be aware of when this announcements are going to be made. This is all part of my risk management process, and as far as my fundamental analysis goes.

Finally, when looking to see a reversal in a trend I look for what I call a 'staircase' pattern forming. The price channels helped to frame and identify this. On this chart, there was no upwards staircase being formed (refer to the definition of a trend here which will help you understand the staircase pattern I look for).

Therefore, even if you did not know the story of the company, a simple visual inspection of the chart over the last year or so, combined with the lack of a staircase pattern forming, would have made this an avoid for me.

Either way, a gap down against you like these could lead to a significant loss of trading equity overnight. You never know what is around the corner, whether it is an anticipated earnings release or trading update, or a completely unexpected news release. Another reason why having strong risk management is a critical part of your overall trading strategy.