Gap Trading

Gap Trading: How to Play the Gap

Gap Trading: How to Play the 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.

Key Takeaways

  • Gaps are spaces on a chart that emerge when the price of the financial instrument significantly changes, with little or no trading in between.
  • Gaps can occur unexpectedly as the perceived value of the investment changes, due to underlying fundamental or technical factors, such as an earnings disappointment.
  • Gaps are classified as breakaway, exhaustion, common, or continuation, based on when they occur in a price pattern and what they signal.

Gap Basic:

Gaps occur because of underlying fundamental or technical factors. For example, if a company’s earnings are much higher than expected, then the company’s stock may gap up the next day. This means that the stock price opened higher than it closed the day before, thereby leaving a gap.

In the forex (FX) market, it is not uncommon for a report to generate so much buzz that it widens the bid-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.

Automated program trading (i.e., algorithmic trading) is a relatively new source of gap price action. The algorithm might signal a large buy order if, for example, a prior high is broken. The size of the algorithmic order may be such that it triggers a price gap, breaking above the recent high and drawing in other traders to the directional movement.

Gaps can be classified into four groups:

  • Breakaway gaps occur at the end of a price pattern and signal the beginning of a new trend.
  • Exhaustion gaps occur near the end of a price pattern and signal a final attempt to hit new highs or lows.
  • Common gaps cannot be placed in a price pattern—they simply represent an area where the price has gapped.
  • 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.

To Fill or Not to Fill:

When someone says a gap has been filled, this means that 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, if it hasn’t already happened in after-hours trading. 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 stock 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:

  • Once a stock has started to fill the gap, it will rarely stop, because there is often no immediate support or resistance.
  • Exhaustion gaps and continuation gaps predict the price moving in two different directions—be sure you correctly classify the gap that you are going to play.
  • Retail investors usually exhibit irrational exuberance; however, institutional investors and algorithmic systems may play along to help their portfolios, so be careful when using this indicator and wait for the price to start to break before taking a position.
  • Be sure to watch the volume. High volume should be present in breakaway gaps, while low volume should occur in exhaustion gaps.

 Gap Trading Example

 The daily chart of Apple Inc. (AAPL) above shows many gaps, which is quite normal given the propensity for equities to gap above or below the previous day’s price action, when the market is closed but news is still forthcoming and filtering into the market price.

Let’s take a closer look at some of the gaps that occurred. Starting from the left, we can see a bullish engulfing line, suggesting the move lower may be reversing (candlestick analysis). This is followed by a bullish gap higher, further suggesting that a low is being formed. An attempt at the downside is made again, but another large bullish engulfing line signals a low may have been made.

In the center, we see a bearish exhaustion gap, indicating that the move higher is running out of steam and may be reversing. The gap is filled relatively quickly, but it continues to act as resistance (horizontal yellow arrow), suggesting that downside potential remains. Finally, on the right side, in the midst of a reversal higher, we see a strong runaway gap indicating further upside potential.

As you can see, gaps are important price developments, leaving some in the dust and others to quick profits. At the minimum, gaps are important features of a security’s price action and should be monitored closely for potential trading opportunities.

What is a gap?

 A gap occurs when the price of a security moves quickly through a price level, either up or down, with little trading or pricing available over that time span.

What causes gaps?

Gaps can be caused by several factors, but they are mostly seen as a result of unexpected news or a technical breach of support or resistance.

On the fundamental side, the news could be a company beating earnings estimates by a large margin, or a speech by a Federal Reserve (Fed) official impacting interest rate expectations.

On the technical side, gaps can ensue following the break of a prior high/low, or other form of technical resistance or support, such as a key trend line.

How can I take advantage of a gap?

By definition, gaps occur quickly and without notice, making it difficult to position in advance of a price gap. You might be lucky and long a security, and it gaps higher, leaving you with a quick profit, or vice versa.

The other approach is to enter the market in the direction of the gap as it potentially moves to close the gap. If the gap is sustainable, then the gap price level/zone should provide an opportunity to get in on the directional move of the gap at a better price.

What happens when a gap is filled, and the price keeps going?

When a gap is filled and later surpassed, it’s a strong signal that the gap was unsustainable in the first place, or news emerged indicating that the gap was in the wrong direction. In such an instance, you may consider taking the opposite position than the gap suggested.

For example, let’s say a stock has gapped to the upside through a significant prior high. Normally, you might look to buy if the gap is filled and the breakout price level holds. However, if that level is surpassed to the downside, you might consider the gap as a false break, and exit longs and take a short position following the upside rejection of the price movement.

The Bottom Line

A gap occurs when the market price of a security jumps to another price level, either higher or lower, where little if any trading has taken place. A good example is an unforeseen comment from a senior Fed official regarding the direction of interest rates. Once the comment hits the newswires, markets may react immediately, with market makers pulling their bids and offers. This may cause a price gap from the last price at $25.20 to $26.50, for example.

Gaps are frequently seen in price charts of almost every security. In stocks, the most frequent and significant gap occurs between the daily close and open of the exchange. In FX markets, since they operate 24 hours a day, a gap may not be visible (possibly on a one-minute chart) but instead appears as a very long candlestick covering the gap in price. (FX markets may experience gaps over the weekend, between the Friday New York close and the Sunday Asia opening.)

Price gaps can bedevil traders, especially if they’re on the wrong side of the gap. The most attractive trading opportunity with gaps is to go long or short as the market moves to close, or fill, the gap. In the example above, a reasonable trade strategy would be to buy the security that has broken higher from $25.20, in a zone between $25.20 and $26.50, in case it doesn’t completely fill the gap. Should the price eventually fall back below the breakout price of $25.20, it may suggest that the gap higher was unsustainable and that the downside remains most in play.

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