In volatile markets, traders can take advantage of significant price jumps in assets, turning these fluctuations into opportunities for profit. Gaps, which appear on a price chart when an asset moves sharply up or down with little or no trading activity in between, create distinct breaks in the price pattern. These gaps are visible on most trading platforms as a sudden shift in price levels. Skilled traders often interpret these gaps to capitalize on potential profit opportunities, using them as a strategic entry or exit point.
Gap Basics
Gaps occur due to various underlying fundamental or technical factors. For example, if a company’s earnings significantly surpass expectations, its stock may experience a “gap up” the following day. This happens when the stock price opens higher than the previous day’s closing price, leaving a visible gap on the chart.
In the forex (FX) market, it’s not unusual for a major report to generate so much attention that the bid-ask spread widens, creating a significant gap. Similarly, a stock reaching a new high during a trading session may open even higher in the next session, resulting in a gap up for technical reasons.
Automated program trading, including algorithmic trading, is another source of gap formation. For instance, if an algorithm detects a price break above a prior high, it might trigger a large buy order. This order may be significant enough to cause a price gap, drawing other traders into the market trend.
Gaps can be categorized into four main types:
1. Breakaway Gaps: These occur at the end of a price pattern, signaling the beginning of a new trend.
2. Exhaustion Gaps: Found near the end of a price pattern, exhaustion gaps indicate a final push to reach new highs or lows.
3. Common Gaps: These do not follow any specific price pattern and simply represent areas where the price has gapped.
4. Continuation Gaps (Runaway Gaps): These occur in the middle of a price pattern, signaling a strong rush of buyers or sellers who share a common belief in the asset’s future movement.
Filling the Gap
A gap is considered “filled” when the price moves back to its original pre-gap level. Gap fills are common and typically occur due to three main factors:
1. Irrational Exuberance: The initial price spike may have been driven by overly optimistic or pessimistic sentiment, leading to a correction as the market adjusts.
2. Technical Resistance: When prices move sharply without establishing any clear support or resistance levels, the lack of a stable price base can result in a gap being filled.
3. Price Pattern: Certain price patterns help predict whether a gap will be filled. Exhaustion gaps, which signal the end of a price trend, are more likely to be filled. On the other hand, continuation and breakaway gaps confirm the current trend and are less likely to be filled.
When a gap is filled within the same trading day, it is referred to as fading. For instance, a company may report strong earnings, leading to a significant price gap up at the market open. However, as the day progresses, traders may spot weaknesses in the company’s financials, such as in the cash flow statement, and begin selling. As a result, the price returns to the previous day’s close, filling the gap. Many day traders employ this strategy, particularly during earnings season, when market sentiment can shift rapidly.
How to Play the Gaps
Traders can leverage gaps in various ways, with a few popular strategies standing out. One approach is to buy after-hours when positive earnings are released, expecting a gap up the next trading day. Others might buy into highly liquid or illiquid positions at the start of a price movement, aiming for a continued trend.
Some traders opt to fade gaps by taking positions in the opposite direction, often using technical analysis to determine high or low points. For example, shorting a stock after a speculative gap up. Another strategy is to buy when the price reaches prior support after the gap has been filled.
Key tips for trading gaps:
- Stocks rarely stop once they start filling a gap, as no immediate support or resistance is present.
- Correctly classify the gap type (exhaustion or continuation) to predict price direction.
- Retail traders may act irrationally, so be cautious and wait for confirmation before entering a position.
- Monitor volume: High volume indicates breakaway gaps, while low volume suggests exhaustion gaps.
Gap Trading Example
This daily chart of Apple Inc. (AAPL) shows several gaps, which is common due to market closure while news impacts prices. Starting on the left, a bullish engulfing line signals a potential reversal, followed by a bullish gap confirming a low is forming. After another attempt to move lower, a second bullish engulfing line appears, further indicating a low.
In the center, a bearish exhaustion gap suggests the upward momentum is fading. The gap is filled quickly but continues to act as resistance, signaling potential downside. On the right, a strong runaway gap indicates further upside potential as the trend reverses upward.
In summary, gaps are crucial price patterns that can offer significant trading opportunities. They should be monitored closely for entry or exit signals based on market movements.
CONCLUSION
Gap trading presents unique opportunities for traders to capitalize on sudden price movements caused by fundamental or technical factors. By understanding the different types of gaps—such as breakaway, exhaustion, common, and continuation gaps—traders can better anticipate potential market behavior and use gaps as entry or exit points. The key is to correctly identify the type of gap and monitor volume and market conditions. While gaps can signal profitable moves, they also come with risks, making it essential for traders to approach them with careful analysis and a solid strategy.
