When a stock makes a big gap higher, whether it be on news, earnings, or otherwise, these equities can turn into momentum plays. Essentially, fundamentals will be set aside and the stock will trade higher day after day. Tesla Motors (TSLA), which is featured below in a weekly chart, is a prime example of this. Seemingly every day the stock trades higher. You can see the incredible move that it has made. TSLA is up almost four fold from its March ~$40 price of this year!
If you chased the stock in the early Spring months of 2013, then you probably made a killing. When an equity gaps higher, it is tough to sit back and watch it climb higher. Even if you held onto a name like TSLA, it didn’t come without its share of hiccups, as there were plenty of sharp down days where profit taking most likely occurred. This type of action is very typical, and I want to illustrate with three stocks where we have seen a recent sell-off shortly after a gap higher.
Facebook (FB) earnings for Q2 of this year were much better-than-expected. The company guided higher for next year, and beat analyst estimates. Per the daily chart (below) you can see the gap higher on earnings, and the move higher the next few days. To be sure, it is certainly possible to make quick trades around this type of action (long or short) but if you are looking at shorter-term to more intermediate-term swing trades, then chasing a stock all the way up here can be considered a low probability play. Once a stock gaps up like this, expect some profit taking to follow shortly after.
This same type of setup is evident in both Groupon (GRPN) and Trip Advisor (TRIP) featured in the charts below. The daily charts show a gap higher on earnings, and several days of higher price action. However, note the sharp sell-off in TRIP. If you were caught chasing the stock all the way up here, you could have paid for it in a big way.
When looking at names that will show potential follow-through, you need to consider more than just the gap higher. Stocks can certainly make unexpected moves and continue going up for no apparent reason. Just remember that the more overbought a stock becomes, the more likely a violent move to the downside is going to come via profit taking.