Trading the Gap: What are Gaps & How to Trade Them?

what is gap trading

As you develop your gap trading strategy, it’s beneficial to explore other trading strategies that can complement your approach. Swing trading, for example, is a strategy that aims to capture gains in a stock within an overnight hold to several weeks. It can provide a different perspective on market trends and price movements, which can be particularly useful when dealing with price gaps. To delve deeper into this strategy, check out this article on Swing Trading Strategy. While gap trading is a powerful tool, it’s important to remember that it’s just one of many strategies available to traders. Diversifying your trading approach can help you navigate different market conditions and optimize your trading performance.

what is gap trading

Read more on the major stock indices and download our free, quarterly equities forecast to boost your understanding of the markets and help you trade more consistently. Common gaps simply show a gap in price action independent of price patterns and usually don’t provide exciting trading opportunities. Gap down stocks and gap up stocks refer to the direction of the price movement either side of the gap.

Gap Down Trading Strategy

Bear in mind that a gap can also occur when you are holding a position overnight. Therefore, it is also crucial to closely follow the economic calendar, companies earning results, and commodities reports. Additionally, while gaps are mostly defined by an area with no trading activity, some types of gaps, like the Fair Value gap, have different patterns and are not formed with a blank area on a price chart. If technical or fundamental factors point to the potential for a gap on the next trading day, it may be time to enter a position.

A full gap down is when the opening price is lower than the prior low price, while a full gap up (as shown above) occurs when the opening price is greater than the prior high price. A gap refers to the area on a chart where no trading activity has taken place. This will appear as an asset’s price moves sharply up or down with nothing in between, meaning the market has opened at a different price to its prior close. More details on each of the aforementioned gap trading strategies is outlined below. These studies show the wide variance of the available data on day trading profitability.

  1. Price gaps can result in significant price movements, and traders who correctly predict these movements can make substantial gains.
  2. Key to this strategy is the rapid execution and close monitoring of the trade, as gaps can close quickly.
  3. He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses.
  4. It’s crucial for investors to recognize the characteristics of different gap types – from breakaway to exhaustion gaps – and understand their implications on stock prices.

So, using the example above, you can see how the market is gapping down and breaking below the opening price. When this happens, the market typically continues in this direction, as the factor that created the gap appears to be insignificant. Well, when you trade the gap, you basically enter a position when the market opens higher or lower from the previous close, expecting the market to close the gap. According to this technique, the gap is likely to get filled, and you are trying to exploit this opportunity. 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.

Either you trade the gap, meaning you are entering a trade with the expectation that the gap will likely be filled, or you wait for the gap to get filled before entering the market. Another strategy, known as the gap and go, involves buying or selling an asset with the assumption that the price will continue to move in the direction of the gap. In general, a stock gapping completely above the previous day's high has a significant change in the market's desire to own or sell it.

What Is the Role of Brokers in Executing Gap Trading Strategies?

In terms of mechanics, gap trading involves identifying and categorizing gaps into common, breakaway, or exhaustion gaps. Each type of gap carries its own significance and implications in terms of trading approach. Traders often rely on technical analysis to detect gaps and assess their potential impact on future price movements. This analysis includes examining factors like trading volume, support and resistance levels, and broader market context. Gap trading is a dynamic and potentially profitable strategy that involves capitalizing on price gaps in stock prices.

what is gap trading

Gap trading, from the perspective of an investor or trader, is a strategy that capitalizes on price gaps which are identified on the price chart of financial instruments. These gaps occur when the opening price of an asset significantly differs from the previous day's closing price, creating a visible gap on the price chart. The gap trading strategy involves identifying price gaps and making trades based on the anticipated price action following the gap. This could involve buying a stock after a gap up in anticipation of further upside movement, or selling a stock after a gap down in anticipation of further downward movement. Traders analyze gaps as part of technical analysis to understand market behavior.

A more conservative approach to this breakaway gap would be to enter on a pullback , which gives the opportunity to test the gap. While it may offer smaller upside, this approach means traders can get away with a much tighter initial stop loss order. Traders can use tools such as the Exponential Moving Average and RSI to ascertain key price points and inform their decisions. For example, the below chart shows how an overbought RSI signal can be used to enter short after an exhaustion gap. When building a gap trading strategy, there are several key factors to consider. The size of the gap, the volume during the gap, and the subsequent price action can all provide clues about the potential trading opportunities.

One of the most common methods is to use horizontal lines on a chart to mark areas where the price has previously bounced off. There are several types of price gaps that can occur in the market, each with its own implications for traders. It’s a strategy that requires precision, quick decision-making, and a thorough understanding of market volatility.

How Do Middle Gaps Influence Trading Strategies?

However, before you decide to use this strategy, you must backtest your trading strategy and realize whether it is the right one for you. On that note, remember that some traders prefer to avoid volatile markets, which is usually the case with the gap trading strategy. An exhaustion gap typically occurs at the end of a long market trend when asset prices are testing new record highs or lows.

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This information is not intended to be used as the sole basis of any investment decision, should it be construed as advice designed to meet the investment needs of any particular investor. 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. A gap being ‘filled’ refers to the price returning to the original level before the gap happened. This usually means the price action, in the following days or weeks, retraces to the last day before a gap.

For example, having detailed knowledge of a given company and its operations can help a trader predict a gap for that stock ahead of an earnings report. Exhaustion gaps are, conversely to continuation gaps, where price makes a final gap in the trend direction, but then reverses. This is often caused by a herd mentality of traders rushing to the trend and moving the stock into overbought territory. Therefore, experienced traders will be watching for the reversal and take the contrary position to the prior trend. Breakaway gaps occur at the end of a price pattern and signal the beginning of a new trend. They are typically accompanied by high volume and can provide significant trading opportunities.

To prepare for gap trading, a trader must have a solid grounding in technical analysis. This includes understanding chart patterns, volume, support and resistance levels, and indicators such as moving averages and RSI. Analyzing past price action of stocks can provide valuable insights into how they might respond to future gaps. Recognizing patterns like breakaway or exhaustion gaps, and understanding their implications, is vital. Traders should be adept at using technical analysis tools to evaluate the strength of a gap and its potential impact on stock price. Always remember, the key to successful gap trading lies in your ability to interpret the data and indicators accurately, not just in recognizing the gap itself.