Gap Basics



Gap Strategies [ video ]



Sources: Investopedia.com and others

 

Gap

In volatile markets, traders can benefit from large jumps in asset prices, if they can be turned into opportunities. Gaps are areas on a chart where the price of a stock (or another financial instrument) moves sharply up or down, with little or no trading in between. As a result, the asset’s chart shows a gap in the normal price pattern. The enterprising trader can interpret and exploit these gaps for profit. This article will help you understand how and why gaps occur, and how you can use them to make profitable trades.

A gap is an area on a technical chart where an asset’s price jumps higher or lower from the previous day’s close. more

Gaps occur when there is empty space between two trading periods that’s caused by a significant increase or decrease in price. For example, a stock might close at $5.00 and open at $7.00 after positive earnings or other news.

Gap Basics

Gaps occur because of underlying fundamental or technical factors. For example, if a company’s earnings are much higher than expected, the company’s stock may gap up the next day. This means the stock price opened higher than it closed the day before, thereby leaving a gap. In the forex market, it is not uncommon for a report to generate so much buzz that it widens the bid and ask spread to a point where a significant gap can be seen. Similarly, a stock breaking a new high in the current session may open higher in the next session, thus gapping up for technical reasons.

Gaps can be classified into four groups:

  • Breakaway gapsoccur at the end of a price pattern and signal the beginning of a new trend. Breakaway gaps –[ “Gap-n-go” ] Breakaway gaps form at the start of a trend.
    *Example…. say market has traded off to be a bit oversold and before the market opens the Fed announces surprise rate cut. That should produce an upside gap… “gap-n-go” would be most likely then. 

 

  • Exhaustion gapsoccur near the end of a price pattern and signal a final attempt to hit new highs or lows. Exhaustion gaps. [ “Gap and Crap” (reverse) ] — Exhaustion gaps for near the end of the trend. 

 

  • Continuation gaps, also known as runaway gaps,occur in the middle of a price pattern and signal a rush of buyers or sellers who share a common belief in the underlying stock’s future direction.
    Runaway gaps — [ “Gap Fill and Resume”] Runaway gaps form during the middle of a trend. Price reverses like “gap and crap”, but once the gap is filled reverses again for perhaps sustained move in the direction of the initial gap.

 

  • Common gapscannot be placed in a price pattern – they simply represent an area where the price has gapped.

 

To Fill or Not to Fill

When someone says a gap has been filled, that means the price has moved back to the original pre-gap level. These fills are quite common and occur because of the following:

  • Irrational exuberance: The initial spike may have been overly optimistic or pessimistic, therefore inviting a correction.
  • Technical resistance: When a price moves up or down sharply, it doesn’t leave behind any support or resistance.
  • Price Pattern: Price patterns are used to classify gaps and can tell you if a gap will be filled or not. Exhaustion gaps are typically the most likely to be filled because they signal the end of a price trend, while continuation and breakaway gaps are significantly less likely to be filled since they are used to confirm the direction of the current trend.

When gaps are filled within the same trading day on which they occur, this is referred to as fading. For example, let’s say a company announces great earnings per share for this quarter and it gaps up at the open (meaning it opened significantly higher than its previous close). Now let’s say, as the day progresses, people realize that the cash flow statement shows some weaknesses, so they start selling. Eventually, the price hits yesterday’s close, and the gap is filled. Many day traders use this strategy during earnings season or at other times when irrational exuberance is at a high.

 

How to Play the Gaps

There are many ways to take advantage of these gaps, with a few strategies more popular than others. Some traders will buy when fundamental or technical factors favor a gap on the next trading day. For example, they’ll buy a stock after hours when a positive earnings report is released, hoping for a gap up on the following trading day. Traders might also buy or sell into highly liquid or illiquid positions at the beginning of a price movement, hoping for a good fill and a continued trend. For example, they may buy a currency when it is gapping up very quickly on low liquidity and there is no significant resistance overhead.

 

Some traders will fade gaps in the opposite direction once a high or low point has been determined (often through other forms of technical analysis). For example, if a stock gaps up on some speculative report, experienced traders may fade the gap by shorting the stock. Lastly, traders might buy when the price level reaches the prior support after the gap has been filled. An example of this strategy is outlined below.

 

Here are the key things you will want to remember when trading gaps:

 
 

Gap Trading Example

To tie these ideas together, let’s look at a basic gap trading system developed for the forex market. This system uses gaps to predict retracements to a prior price. Here are the rules:

 
  1. The trade must always be in the overall direction of the price (check hourly charts).
  2. The currency must gap significantly above or below a key resistance level on the 30-minute charts.
  3. The price must retrace to the original resistance level. This will indicate the gap has been filled, and the price has returned to prior resistance turned support.
  4. There must be a candle signifying a continuation of the price in the direction of the gap. This will help ensure the support will remain intact.
 

Because the forex market is a 24-hour market (it is open 24 hours a day from 5:00 pm EST on Sunday until 4:00 pm EST Friday), gaps in the forex market appear on a chart as large candles. These large candles often occur because of the release of a report causing sharp price movements with little to no liquidity. In the forex market, the only visible gaps on a chart happen when the market opens after the weekend.

 

Let’s look at an example of this system in action:

 
Image 1
Image by Julie Bang © Investopedia 2020

The large candlestick identified by the left arrow on this GBP/USD chart is an example of a gap found in the forex market. This does not look like a regular gap, but the lack of liquidity between the prices makes it so. Notice how these levels act as strong levels of support and resistance.

 

We can see in Figure 1 that the price gapped up above some consolidation resistance, retraced and filled the gap, and finally, resumed its way up before heading back down. We can see there is little support below the gap, until the prior support (where we buy). A trader could also short the currency on the way down to this point if he or she were able to identify a top.

 
 

Gaps are risky—due to low liquidity and high volatility—but if properly traded, they offer opportunities for quick profits.

The Bottom Line

Those who study the underlying factors behind a gap and correctly identify its type can often trade with a high probability of success. However, there is always a chance the trade will go bad. You can avoid this first, by watching the real-time electronic communication network (ECN) and volume. This will give you an idea of where different open trades stand. If you see high-volume resistance preventing a gap from being filled, then double-check the premise of your trade and consider not trading it if you are not completely certain it is correct.

 

Second, be sure the rally is over. Irrational exuberance is not necessarily immediately corrected by the market. Sometimes stocks can rise for years at extremely high valuations and trade high on rumors, without a correction. Be sure to wait for declining and negative volume before taking a position. Last, always be sure to use a stop-loss when trading. It is best to place the stop-loss point below key support levels, or at a set percentage, such as -8%.


For more insight, read Playing the Gap

 

Exhaustion Gap

An exhaustion gap is a gap that occurs after a rapid rise in a stock’s price begins to tail off.more

Runaway Gap

A runaway gap is a type of gap on a price chart that occurs during strong bull or bear movements. more

Upside Tasuki Gap

An Upside Tasuki gap is a candlestick formation that is commonly used to signal the continuation of the current trend. more

Piercing Pattern

A piercing pattern is a technical trading signal that is formed by a closing down day with a good-sized trading range, followed by a trading gap lower the following day with a white candlestick that covers at least half of the upward length of the previous day’s red candlestick body, finishing with a close higher for the day. more

 

 

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