Trading methods that take advantage of charts gaps resulting from price changes between sessions are known as gap trading strategies. Continue reading to learn more about the gap phenomena, the four varieties to watch out for, and how to use a gap trading method.
WHAT IS A GAP?
The region on a chart where no trading activity has occurred is referred to as a gap. This will manifest as a sudden up or down move in an asset’s price with no pause, indicating that the market began at a different price than its previous close.
Why is there a gap? Fundamental causes are the most common reason. For instance, in the graph above, ASOS shares increased overnight as investors bet the firm could address severe operational problems after its full-year results revealed it avoided another profit warning.
Gaps may result from other news, including product launches, analyst promotions and demotions, and new senior positions. This is due to their ability to affect the market in either way between trading sessions drastically.
Gap down vs. Gap up stocks
Stocks with a gap up or down indicate the direction of the price movement on either side of the gap. A wide gap up, as seen above, occurs when the opening price is higher than the preceding high price, and an entire gap down happens when the starting price is lower than the prior low price.
THE FOUR TYPES OF GAPS IN TRADES
Depending on where they appear on a chart, there are four primary kinds of gaps in addition to gaps down and up: common gaps, breakaway gaps, continuation or runaway gaps, and fatigue gaps.
1.) Common gaps often don’t provide exciting trading chances since they only display a price movement gap independent of price patterns.
2.) Breakaway gaps signify a new trend when the asset ‘gaps away’ from the price pattern, as seen below when the gap initiates a breakout. If a breakaway gap is accompanied by increased trading volume, it may be worth putting a long position on the candle after the gap and a short position on the candle following the gap. (See our example of gap trading below.)
3.) Runaway or continuation gaps indicate an intensification of an existing bullish or bearish pattern in the same direction. A news story that supports the mood and feeds the trend may be the culprit. For a bullish runaway gap, traders may want to follow the trend and set a stop just below the gap; for a bearish runaway gap, they may want to set a stop just above the gap.
4.) Exhaustion gaps, on the other hand, occur when price produces a last gap in the trend direction but then reverses. This is often brought on by traders adopting a herd mentality and jumping on the trend, pushing the stock into overbought territory. Experienced traders will thus be on the lookout for a reversal and adopt the opposite stance from the preceding trend.
WHAT DOES IT MEAN WHEN A GAP IS ‘FILLED’?
When a gap is “filled,” the price returns to where it was before it appeared. This often indicates that the price movement will retrace to the last day before a gap in the days or weeks that follow.
The following variables are relevant when discussing gap-fill stocks:
- Price corrections: An unduly optimistic or gloomy early increase may encourage a correction.
- Support and resistance are still possible when a price increases quickly.
- Price patterns: They determine the chance of a gap being filled. For instance, exhaustion gaps, which indicate the conclusion of a price trend, are likely to be filled when price reversals are seen.
GAP TRADING STRATEGIES & TIPS: Trading the Gap
You may experiment with various gap trading strategies, such as fading, gap prediction, and price action indicator use.
- Closing the gap
Gaps that are filled on the trading day they occur are known as “fading the gap.” Imagine a stock that, after a strong earnings report, surged at an opening price higher than the previous closing. As the day continues, traders examine the company’s presentation deck in more detail, find items they don’t like, and begin selling. The gap is eventually bridged when the price reaches yesterday’s closing.
When it comes to fading the gap, irrational enthusiasm from less experienced traders may benefit more seasoned market practitioners since the volume that creates FOMO often drives the gap in trading.
- Forecasting a gap
It could be appropriate to initiate a trade if fundamental or technical indicators suggest that there might be a gap on the next trading day. For instance, thorough familiarity with a specific business and its operations might assist a trader in anticipating a gap for that stock before an earnings announcement.
- The use of indicators
To identify essential price points and guide their judgments, traders might utilize indicators like the RSI and the Exponential Moving Average. The chart below, for instance, demonstrates how to enter short following an exhaustion gap using an overbought RSI indicator.
The following graph illustrates a forceful response to the breakaway gap scenario. It shows where a long position is taken in reaction to the spike in trading volume after a gap and a potential first-stop loss level to guard against the increased risk.
Entering on a pullback, which allows the chance to test the gap, would be a more cautious strategy for this breakout gap. With this strategy, traders may get away with a much tighter first-stop loss order, even if the upside potential may be lower.
GAP TRADING RULES: IMPORTANT FACTORS TO REMEMBER
Determine which of the four gap types you have discovered by classifying the gap you want to play. A trend will be prolonged by a continuation gap, while an exhaustion gap will reverse it.
Due to the lack of immediate support or opposition, it seldom stops once a gap has begun to fill.
Has a decision been driven by amateur or experienced investors? Waiting for the price to start to break before taking a position could be a good idea since inexperienced investors often display little excitement, creating an exhaustion gap.
Be mindful of the loudness. High volume is often seen during breakaway gaps (see trade example above), but low volume is expected during exhaustion gaps.
Be cautious. Trading the gap entails trading low liquidity stock market volatility. Thus care must be used. To ensure you’re trading with the appropriate attitude and managing risk effectively, read about trading psychology and utilizing stop-loss orders.