Gap trading is a popular trading strategy used by many traders to generate quick profits. It involves identifying and exploiting price gaps that occur in volatile markets between the closing price of the previous day and the opening price of the next to apply this strategy successfully apply this strategy.
Basics of Gaps
Gaps are price differences between the closing price of one trading day and the opening price of the next trading day. These can occur due to fundamental or technical factors. For example, if a company's earnings are much higher than expected, the company's stock may have a price gap the next day. This means that the stock price opens higher than it closed the previous day, creating a gap.
There are four different types of gaps:
- Breakaway Gaps occur at the end of a chart pattern and signal the beginning of a new trend.
- Exhaustion Gaps occur near the end of a chart pattern and signal a final attempt to reach new highs or lows.
- Common Gaps cannot be inserted into a chart pattern - they simply represent a range in which the price has a gap.
- Continuation Gaps, also known as Runaway Gaps, occur in the middle of a chart pattern and signal a surge of buyers or sellers who believe in the future direction of the underlying stock.
What does "filling gaps" mean?
If someone says that a gap has been "filled", it means that the price has moved back to the original pre-gap level. This "filling" happens quite often and occurs for the following reasons:
- Irrational exuberance: The initial rise could have been too optimistic or pessimistic, leading to a correction.
- Technical resistance: When a price moves strongly up or down, it doesn't leave behind support or resistance.
- Price patterns: Price patterns are used to classify gaps and can provide insight into whether a gap will be filled or not. Exhaustion gaps are usually the most likely to be filled, as they signal the end of a price trend, while Continuation Gaps and Exhaustion Gaps are much less likely to be filled, as they serve to confirm the direction of the current trend.
If gaps are closed within the same trading day on which they occur, this is called fading. For example, a company announces that it has achieved great earnings per share this quarter and opens with a price gap (i.e., it opens significantly higher than the previous closing price). However, during the day, the stock is sold off due to different factors. Eventually, the price reaches the previous day's closing price and the gap is closed. Many day traders use this strategy during earnings or at other times when irrational euphoria is high.
How to Profit from a Gap
By definition, price gaps occur quickly and unexpected, making it difficult to position oneself ahead of a price gap.
If you are lucky enough to hold a long position in a gap, you can make a quick profit or vice versa.
The other approach is to enter the market in the direction of the gap, as the price may be moving towards the direction to fill the gap. If the gap is persistent, the gap enter the direction of the gap at a better price.
What happens when a gap is filled, but the price continues to rise or fall?
If a gap is filled and later even exceeded, this is a strong signal that the gap was not sustainable from the beginning or that news has emerged indicating that the gap went in the wrong direction. In such a case, one considers taking the opposite position as suggested by the gap.
For example, suppose a stock breaks a significant previous high to the upside. Normally, one would buy when the gap is filled and the breakout level holds. However, if this level is subsequently broken downwards, one can consider the gap as a false breakout, abandon the long position, and take a short position after the upward price movement is rejected.
Gaps can be very risky! However, if you know what you're doing, they offer good trading opportunities.
Conclusion
A price gap occurs when the market price of a security jumps to another, higher or lower price level where little or no trading occurred before. A good example of this is an unexpected statement by a high-ranking Fed official about the direction of interest rates. Once the announcement appears on news tickers, markets can react immediately by withdrawing their bids and offers. This can already lead to gaps.
Gaps are visible in the charts of almost all financial instruments. In stocks, the most common and significant price gap occurs between the daily close and the opening price of the exchange. As the forex markets are open around the clock, a price gap may not be visible (possibly on a one-minute chart), but appears as a very long candle that covers the price gap. (Price gaps can occur in forex markets over the weekend, i.e., between the closing price on Friday in New York and the opening on Sunday in Asia).