A gap in your trading chart could be advantageous if you spot it.
Maybe it’s blip on your screen, or maybe you just haven’t had enough coffee at the start of your trading day, but you notice a break between prices in your chart that wasn’t there yesterday. If that space is still there after you’ve finished your cup of coffee, you might be seeing a trading gap.
Luckily for you, a gap like this could be an opportunity to make a trade.
WHAT IS A GAP?
A gap is an area on a chart that shows where the price of a security moves dramatically up or down, with little or no trading in between. In the stock market, traders can find gaps in the time between the close of a trading day and when the market opens the next day. Generally, market technicians classify a gap by a five percent increase from the previous closing high of an “up” candlestick to the new opening price of the next candlestick, or a five percent decrease from the previous closing low of a “down” candlestick to the new opening price of the next candlestick.
Identifying a gap can be an important trend indicator for traders, as they may signal the direction of a security’s price. Traders typically classify these gaps into four categories: common, breakaway, runaway, and exhaustion gaps. Determining the gap’s category early can help traders take advantage of those gaps.
Your adrenaline might start pumping at the sight of a gap in a chart, but try not to let your emotions escalate too quickly; not all gaps are signs of a powerful market shift. Most are known as “common gaps,” which happen regularly during the normal course of trading. Usually, there is no major event that precedes them. Common gaps are also known as “temporary gaps,” “area gaps,” or “pattern gaps.”
Traders can usually identify a common gap by its minor size, frequency, and lack of volume. Because of this, common gaps tend to fill relatively quickly. Because of this, they may not provide any real analytical insight. However, since the market tends to fill the gap so quickly, one strategy is to trade common gaps in the opposite direction.
Much like the athlete who sprints toward the goal on a breakaway, the similarly named gap can lead to an exciting turn in the market. A breakaway gap happens when the price gaps above resistance or gaps below support, meaning they break away from an area of congestion. As the price moves away from its support or resistance line, this breakaway gap may signal changing market sentiment and the start of a new trend.
Before you classify a gap as a “breakaway,” be sure you see an increase in volume. Before the breakaway, the volume may seem consistent, but after the gap point the volume should be higher than the volume before to confirm a change in mood. You can also identify a breakaway by matching it to chart patterns, such as ascending or descending triangle patterns.
A runaway gap ― also known as a continuation gap ― occurs when trading activity skips sequential price points in the midst of strong uptrends or downtrends. This may point to the direction of the underlying trends and is usually motivated by intense interest from investors. Often, these runaway gaps happen after a security has a breakaway gap.
The sudden increase in buying or selling frequently happens after a product launch or an unexpected news event, which encourages bids and offers to start at price points farther away from the last traded price before the gap. Traders who are motivated by panic are more likely to trade at wide price levels.
Runaway gaps can signal a strong underlying trend, prompting traders to enter in the direction of the trend after the gap occurs. Traders can build their confidence in identifying runaway gaps by looking for high volume and triangle pattern trends for confirmation.
Exhaustion gaps signal the downward trend of a move. These kinds of gaps show that buyers are exhausted and no longer have enough orders to meet the number of new sellers. This can be one of the most exciting but also the most dangerous market moves, as anticipating them can be difficult for inexperienced traders. After spotting an exhaustion gap, advanced traders tend to enter in the opposite direction of the trend.
When evaluating gaps, identify the motivations for the abrupt change. For example, amateur investors tend to exhibit uncontrolled fervor that can set up an exhaustion gap; therefore, waiting for the price to start to break before taking a position can be helpful.
Still, traders should exercise caution. Trading the gap means there is high market volatility with low liquidity. Incorporating trailing stop orders, setting proper entry and exit rules, and monitoring support and resistance levels can balance your strategy while trading the gap.