Methanex – a Textbook Gap Trade

by Craig on 18/01/10 at 8:36 am

On the 11th, we wrote a somewhat detailed post called ‘Trading a Gap Higher or Lower‘ in which we analyzed the trading patterns of companies following either a gap higher or lower. A trading gap occurs when the price jumps higher or lower from one day to the next by a certain degree, thus creating a gap in the trading line. We found a gap of 2% or greater is typically followed by an upward movement in the stock price if the gap was to the upside.

In the January 11th post last Monday, we highlighted Methanex to keep an eye on as the company had just gapped to the upside and to see if the gap would be followed by an additional move higher in the share price. As it turned out, this was a textbook case of a positive gap as the first day following the gap was rather mixed then the share price began to move higher (chart).

Once the gap higher was confirmed at the close on Monday, an investment at the open on Tuesday would be up from $23.70 to $25.06 based on Friday’s close. 5.7% over four days, not bad. There may be more upside ahead, as our work on positive 2% or higher gaps showed the positive performance builds over the 10-day measurement period.

But Gaps Don’t Always Work

We are not contending gaps are the perfect trading signal and acknowledge there are occasions when the gap does not foretell share price direction. RIM in mid December was a classic case of a gap gone wrong. After the close on Thursday December 17th, RIM reported a blowout quarter and the share price gapped higher at the open on Friday. Purchasing shares at the open on Monday would be losing trade from the very first day’s close.

This demonstrates the importance of using a stop loss on these types of short term trading ideas. A stop 3% below the purchase price would limit any potential loss if the typical trading pattern fails to develop. But buying shares after a 2% gap to the upside has been profitable about 2/3rds of the time. And if you can limit the damage on the other third, this can prove a profitable strategy.

Gaps from Friday

Among the TSX constituents, there were two companies that gapped by 2% or greater on Friday. Taseko Mines Ltd. (TSX:TKO) gapped 8.2% higher on news of environment government approval of their planned gold & copper mine in B.C.  With a close of $5.17, we would be buyers at the open today with a stop-loss of $4.95. Or alternatively, wait for today’s trading to consolidate Friday’s gains and enter near the close or the open tomorrow morning.

The other gap was Extendicare Real Estate Investment Trust (TSX:EXE.un) which declined by 2.5% on news of a secondary equity offering. We wouldn’t trade this one. Equity offerings are often accompanied by efforts by the underwriters to keep the share price stable and above the issue price. But there is also those who will short the shares if they rise too far above the issue price and cover with their allotment. Clearly too many different pressures, so we would pass on trading this gap.