From time to time, you’ll be able to notice price gaps when trading the markets – these are blank areas in a trading chart where an asset’s price opens higher or lower from the previous day’s close.
Generally, it is quite common that gaps tend to get filled at some point in time, which could be a great opportunity to make trading decisions and take advantage of these price gaps. So, let’s see how you can add this tool to your trading arsenal.
Here what’s included in this article:
Key Points to Take Away
- In trading, gaps are blank areas in a trading price chart that usually tend to get filled.
- There are four types of trading gaps – common, breakaway, continuation, and exhaustion.
- Gaps typically occur due to unexpected fundamental and technical events during times when the markets are closed.
What is a Gap in Trading?
First, in my view, the best way to explain a gap in trading is to see gapping happens on a candlestick chart.
As you can see in the chart above, a gap is simply an area in a chart where no trading activity has taken place, and there’s a sort of empty space from the previous closing price displayed in candlestick and bar charts. In financial terminology, this is known as gapping and is exactly what happened in the chart above when Amazon stock opened higher and in the following three trading days, the gap was filled.
As we already know, due to the herd behavior in financial markets, a lot of people are looking at the same charts and are taking similar trading actions. Hence, many experienced traders exploit these gaps to make profitable trades.
Types of Gaps
There are 4 types of gaps’ price patterns you can find on trading charts. These are:
A common gap, also known as an area gap, is a price gap that occurs without any pattern or shape. These gaps normally happen due to technical reasons and in most cases tend to get filled quickly. (see image above)
A breakaway gap is an untraded region that occurs at the end of a trend, or more accurately, at the end of a period when the market is in consolidation. Usually, it marks the end of the previous sideways region and the beginning of a new trend. Generally, breakaway gaps are less likely to get filled and if they do, it usually takes a long time for the gap to be filled.
Continuation (Runaway) Gap
As the name implies, continuation gaps usually occur in the middle of a price trend. So, when a continuation gap is identified, it means that the trend is very likely to continue. A runaway gap is also characterized by a significant gap and high volume.
An exhaustion gap typically occurs at the end of a long market trend when asset prices are testing new record highs or lows. As a result, this type of gap signals a taking profit condition and a reversal of the prior trend. As you can see in the chart below, once the exhaustion gap occurs, the price moves in the opposite direction.
Why Does a Price Gap Occur?
Apart from the cryptocurrency market, all other markets have opening and closing times. The forex market, for instance, is open 24/5 and is closed on Saturday and Sunday. Most stock markets around the world are open for 8-9 hours a day. This leaves plenty of time for unexpected events to influence assets’ prices in times when the markets are closed. Then, when the market reopens again, the fundamental factor that was released is being priced in and thus, the gaps occur when a financial instrument opens at a lower or a higher price.
As a matter of fact, central banks and private companies often prefer to release important data at times when the markets are closed (They usually do that to reduce volatility and market noise). Eventually, these unexpected events such as earnings reports, economic data, and political issues may create a gap in the market.
Bear in mind that a gap can also occur when you are holding a position overnight. For that reason, it is also crucial to closely follow the economic calendar, companies earning results, and commodities reports.
So, all things considered, gaps are usually created by fundamental underlying factors, especially in the stock market. In the foreign exchange market, it is not very common to find gaps as the market runs 24 hours five days a week. However, in some cases, you might be able to identify a gap in certain currency pairs on Sunday/Monday when the market opens.
How to Trade Gaps?
Before we delve into the details, you should know that trading the gaps does not actually involve the use of any complex trading strategies, and is usually not a trading strategy you could solely focus on. Most likely, you are not going to search price gaps in the market and make it your top strategy. Still, it’s a good trick and an interesting way to ‘hack’ the markets.
In my opinion, it is best to keep this method of trading in the back of your mind when you start trading and occasionally enter trades when you identify a gap in a certain market.
So, how does it work? In a nutshell, traders who use gap trading strategies try to identify gaps between the opening price and the closing price on a trading chart and use these gaps as the main reason to buy or sell an asset. The decision obviously depends on the asset’s market sentiment and the type of gap price pattern that was formed. However, this is the main rationalism behind this type of trading – once a trader notices the market is about to close the gap, the trader predicts that the price will cover all the gap regions, which gives the trader an evaluation of the next price movement.
Keeping the above in mind, here are some basic rules to take into account when trading gaps:
- Try to identify the type of gap and the market sentiment before the gap was created
- Follow the news and make sure you understand what caused the gap
- Always wait for the first candlestick to be completed
- If the market goes against you, get out. Once the price reaches near-gap levels, you can enter a trade again.
- Once the asset starts to fill the gap, stay until the end. After the gap occurred and the asset’s price has started to fill the gap, prices rarely stop and typically cover the entire region of the gap.
- Add a volume technical analysis indicator.
So, What’s the Big Deal About Gap Trading?
The bottom line – Much like using Doji candlestick chart patterns in order to make trading decisions, the use of price gaps in trading is something that should come naturally. There’s no need to learn how to use or analyze it – instead, you need to be aware of this occurrence and grab the opportunity whenever you see it.
As a general rule, I wouldn’t say that gaps are always automatically filled. Occasionally, it takes days, weeks, and even months until the gap is filled. However, I don’t think I’ve seen many cases at which a price gap was not filled (unless the asset is illiquid and there’s low volume). So, taking this ‘trick’ and applying it to your trading routine could be extremely useful for you.
Frankly, trading gaps might be a tricky business. While spotting gaps does not require any special trading skills, it could be quite a challenge to identify the type of gap. Still, if you master your skills in identifying the type of gap and when to enter a trade, gap trading offers lots of trading opportunities.
One tip that might be helpful – knowing when to enter a trade once you notice a gap is not an easy task, especially if you are not familiar with the stock or the asset you are trading on. That said, in the vast majority of cases when the asset starts filling the gap, the price will go until the point it fills the entire region. This trading method is something you should take into your decision process and use as much as possible.
As we mentioned in our guide, price gaps are more common in the stock market than in other markets, largely because the stock markets are open for several hours a day. To trade stock gaps, you need to watch the pre-market and the first hour after the stock market opens. Then, once you identify a price gap, wait for the next candle to be completed and try to identify the type of gap. Whenever the stock’s price starts filling the gap, this is your trade – meaning, you need to stay until it covers the entire gap.
Additionally, one of the key things that create gaps in the stock markets is earnings report so it is advisable to always be alert of reports released by public companies.
Generally, there are a few services online that provide a stock screener with alerts about stock gaps. This includes Finviz, Chartmill, and even TradingView. Another way to find stock gaps is to create your own stock screener, and independently find stock gaps during the pre-market session.
Another gap trading strategy is to enter a position once the asset has started to fill the gap, and place the stop loss at the level at which the price hits yesterday’s close. This way, if you believe the asset is going to fill the gap and continue this trend, you can benefit from using the previous close as a protection level and try to ‘squeeze’ the trade.