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 other financial instrument) moves sharply up or down with little or no trading between them. Consequently assetthe chart shows a gap in a normal price pattern. Enterprising dealer can interpret these gaps and use them for profit.
This article will help you understand how and why gaps occur and how you can use them to make profitable trades.
Key things
- Gaps are gaps on the chart that appear when the price of a financial instrument changes significantly, with little or no trading in between.
- Gaps can appear unexpectedly when the perceived value of an investment changes due to underlying fundamental or technical factors such as earnings disappointment.
- Gaps are classified as breakouts, exhaustions, normals, or continuations based on when they occur in the price pattern and what they signal.
Gap Basics
Gaps arise due to fundamental or technical factors. For example, if a company profit are much higher than expected, then the company’s stock may rise the next day. This means that the stock price opened higher than it closed the day before, leaving a gap.
IN forex (FX) marketit is not uncommon for a message to generate so much buzz that it spreads bid-ask spread to the point where a significant gap is visible. Similarly, a stock that breaks a new high in the current session may open higher in the next session, thus jumping for technical reasons.
Automated program trading (ie, algorithmic trading) is a relatively new source of gap price action. The algorithm may signal a large buy order if, for example, a previous high is broken. The size of the algorithmic order can be such that it triggers a price gap, breaking above the recent high and attracting other traders to the directional movement.
Gaps can be divided into four groups:
- Tear-off spaces they occur at the end of a price pattern and signal the beginning of a new trend.
- Exhaustive gaps they occur near the end of a price pattern and signal a last attempt to make new highs or lows.
- Common spaces cannot be placed in a price pattern – they simply represent an area where price has disappeared.
- Gaps in continuationalso 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 future direction of the underlying stock.
To fill or not to fill
When someone says that a gap has been filled, it means that the price has moved back to the original level before the gap. These fillings are quite common and occur for the following reasons:
- Irrational exuberance: The initial surge may have been overly optimistic or pessimistic, thus calling for a repair.
- Technical resistance: When the price goes up or down sharply, it leaves none behind Support, support or resistance.
- Price pattern: Price patterns are used to classify gaps and can tell you whether a gap will be filled or not. Exhaustion gaps are most often filled because they signal the end of a price trend, while the continuance and detachment of the gap they are significantly less likely to be filled because they are used to confirm the direction of the current trend.
If the gaps are filled on the same trading day they occurred, it is referred to as fading. For example, let’s say a company makes a great announcement profit per share for this quarter boy and expands to OPEN (that is, it opened significantly higher than the previous one close). Now let’s say as the day progresses, people realize that statement of cash flows shows some weakness, so they start selling. Finally, the price reaches yesterday’s close and the gap is filled. Many day traders use this strategy during results season or at other times when irrational exuberance is at a high.
How to play spaces
There are many ways to exploit these gaps, with a few strategies more popular than others. Some traders buy when fundamental or technical factors favor a gap in the following trading day. For example, he buys a stock after hours when it is bullish earnings report will be released in hopes of a gap in the following trading day, if this has not already happened in after-hours trading. Traders can also buy or sell for highly liquid or illiquid position at the beginning of the price movement in the hope of a good filling and continuation of the trend. For example, they may buy a stock when it drops to a low very quickly liquidity and there is no significant overhead drag.
Some traders will weaken gaps in the opposite direction once a high or low is determined (often through other forms of technical analysis). For example, if the stock goes up on some speculative news, experienced traders can close the gap short circuit stock. Finally, traders can buy when the price level reaches the previous support after filling the gap. An example of this strategy is shown below.
Here are the key things you’ll want to remember when trading gaps:
- Once a stock starts to fill a gap, it rarely stops because there is often no immediate support or resistance.
- Exhaustion gaps and continuation gaps predict price movement in two different directions – make sure you correctly classify the gap you will be playing.
- Small investors they usually show irrational exuberance; however, institutional investors and algorithmic systems can help them portfoliosso be careful when using this indicator and wait for the price to break through before taking a position.
- Be sure to watch volume. High volume should be present in the tear-off gaps, while low volume should occur in the exhaust gaps.
An example of gap trading
Daily chart of Apple Inc. (AAPL) above shows many gaps, which is quite normal as stocks tend to gap above or below the previous day’s price when the market is closed, but news is still coming in and filtering into the market price.
Let’s take a closer look at some of the gaps that have occurred. Starting from the left, we can see a bullish absorbing line indicating that the move below may be reversed (analysis of candlesticks). This is followed by a bullish gap higher, further suggesting a low is forming. A decline attempt is made again, but another large bullish engulfing line signals that a low may have been made.
In the middle, we see a bearish exhausting gap that suggests the move higher is running out of breath and may reverse. The gap is filled fairly quickly, but continues to act as resistance (horizontal yellow arrow), indicating downside potential remains. Finally, on the right side, in the middle of the reversal above, we see a strong gap indicating further upside potential.
As you can see, gaps are important price developments, leaving some in the dust and others making quick gains. At the very least, gaps are important features of a security’s price movement and should be watched 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 few trades or prices available during that time period.
What causes gaps?
Gaps can be caused by several factors, but 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 that significantly beat earnings estimates, or a speech from the Federal Reserve (Fed) official affecting interest rate expectations.
On the technical side, gaps can form after a previous high/low is broken or another form of technical resistance or support, such as a key trend line.
How can I use the loophole?
By definition, gaps appear quickly and without warning, making it difficult to place a price gap in advance. You might get lucky and long security, and it is higher, so you have a quick profit, or vice versa.
The second 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 price level/gap zone should provide an opportunity to enter the directional movement of the gap at a better price.
What happens when the gap is filled and the price continues?
When a gap is filled and later breached, it is a strong signal that the gap was unsustainable in the first place, or there has been news suggesting that the gap was in the wrong direction. In that case, you might consider taking the opposite position to the proposed gap.
For example, let’s say a stock has broken up from a significant previous high. Normally, you can look to buy if the gap is filled and the breakout price level holds. However, if this level is breached to the downside, you can consider the gap as a false breakout and exit the longs and take a short position after the rejection of the upward price movement.
Gaps are risky – due to low liquidity and high volatility— but if traded correctly, they offer opportunities for quick profits.
Bottom Line
A gap occurs when the market price of a security jumps to another price level, either higher or lower, where there has been little, if any, trading. A good example is the unpredictable commentary from a senior Fed official regarding the direction of interest rates. Once a comment hits the news, markets can react immediately market makers downloading their offers and offers. This can cause a price difference, for example, from the last price at $25.20 to $26.50.
Gaps are often seen in the price charts of almost all securities. For stocks, the most frequent and most significant gap occurs between the daily closing and the opening of the exchange. In the FX markets, since they operate 24 hours a day, the gap may not be visible (perhaps on a minute chart), but instead appears as a very long candle covering the gap in price. (FX markets may see gaps over the weekend between Friday’s New York close and Sunday’s Asian open.)
Price gaps can hurt traders, especially if they are on the wrong side of the gap. The most attractive gap trading opportunity is to go long or short as the market moves to close or fill the gap. In the example above, a reasonable trading strategy would be to buy a security that broke above $25.20, in the zone between $25.20 and $26.50, in case it doesn’t completely close the gap. Should the price eventually drop back below the $25.20 breakout, it may indicate that the gap higher was unsustainable and that the most downside remains in play.
