A gap is when a stock price sharply rises or falls but no trading activity has taken place in that time. This gives the trader an opportunity to take advantage of the imminent change in demand for that stock.
Detailed Description:
What is Gapping?
Have you ever seen a break between the closing and opening price of a stock, without any trading between the prices? If yes, you probably didn’t know that this market phenomenon has its name – it’s called gapping. In this article, we’ll cover why a stock price gaps, what types of gaps exist and what does “gap up” mean in stock trading.Why Does the Stock Market Gap?
Gaps occur when the opening price of a stock differs from its closing price. While we’ll focus on stock gaps, they can also appear in any other financial market. A gap usually occurs in times of low market liquidity, when there are not enough buyers and sellers to prevent sudden drops and spikes in the price.This can even happen in markets which usually have a high volume of trading, such as the Forex market. In the stock market, you’ll usually find gaps after a trading day closes and the market opens the next day again. Important events such as earnings releases and company-related news can impact the market sentiment after the stock closes, leading to gaps in the price of a stock when the stock opens.
Types of Gaps
Depending on the current market condition, not all gaps are the same. Here’s a list of the most common types of gaps:Common gap – As their name suggests, these are the most common gaps in the market. They frequently occur in the stock market when a new trading day starts, or in the Forex market after the weekend trading pause. They can also occur in the middle of the trading day in times of strong buying or selling pressure.
Breakaway gap – A breakaway gap usually occurs at top of uptrends and at the bottom of downtrends, signalling a potential trend reversal. They can also form during breakouts of major chart patterns, and can be intensified by a high trading volume.
Continuation gap – Continuation gaps occur in the middle of strong uptrends or downtrends, in the direction of the underlying trend. They signal that a strong buying pressure exists in uptrends, or that a strong selling pressure exists in downtrends.
Exhaustion gap – Exhaustion gaps form during strong uptrends or downtrends, but in the opposite direction of the underlying trend. They signal that the trend is starting to lose momentum, and that a potential reversal is ahead.
Filled gap – After a gap forms, markets often fill the gap between the closing and opening price. This is especially true with common gaps, and can be used to build a trading system around them.
Playing the Gap
Depending on the type of gaps formed, traders can build a trading strategy and try to profit on them. A gap up or gap down can create profitable trading opportunities if you know how to trade them correctly. As a rule of thumb, here are some points traders need to consider when trading gap:- Common gaps should be traded in the opposite direction, as the market often fills the gap shortly after they occur.
- Continuation gaps signal a healthy and strong underlying trend, and traders can look to enter in the direction of the trend after a continuation gap occurs.
- Exhaustion gaps have a proven track-record of signalling trend reversals, and traders should look to enter in the opposite direction of the trend after they spot an exhaustion gap.
Gaps
are common, especially in the stock market and they can provide information and insights about the underlying market dynamics. A gap is usually created when the closing price of the previous day and the open of the following day have different price levels (see the screenshot below). In times of large volatility, intra-day gaps can also exist.
The 4 gap types
1) Breakaway gap
The breakaway gap describes a gap in price that gaps over a support or a resistance level.The chart below shows the price chart of APPL with a strong resistance level. After the gap was formed, the trend accelerated.
The breakaway gap, thus, shows a trend continuation signal most of the time.
The chart study below shows numerous breakaway gaps through important resistance levels. Each breakaway gap leads to a trend continuation as well.
2) Exhaustion gap
The exhaustion gap usually happens during a trending period and can signal a reversal. Price makes one final gap in the direction of the trend and then reverses.The chart situation below shows two exhaustion gaps into previous support (2) and resistance (1) levels. In both cases, the candles after the gap are representing small Doji candles and, thus, indicate indecision. The following candles are large momentum candles and provide the final signal.
It is recommended to wait for the completion of the candle that confirms the change in direction to avoid running into false signals.
3) Continuation gap
Continuation gaps occur in the middle of trends. In an uptrend, a gap upwards signals a continuation and it shows that additional buyers entered the market to push price higher.Preferably, continuation gaps are not extremely large in size to confirm sustainability. Any extreme price or gap movements might foreshadow a shift in the buyer and seller dynamic.
4) Common gaps
As the name implies, a common gap is nothing extraordinary and it can happen frequently without any major implications about further price movements.Common gaps often occur when price is ranging. These types of gaps are not big in size and get filled relatively quickly. The screenshot below shows the price chart for QQQ. Price is ranging and common gaps occur frequently within the range without any signaling effect.
Thus, it is recommended to avoid trading gaps within a range and without additional confluence factors. The other 3 types of gaps usually provide higher probability trading opportunities.
The gap-fill
The gap-fill is a popular trading strategy and it is used not only in the stock market, but also in Forex.After a gap is formed, it happens frequently that the price eventually returns to the origin of the gap and, thus, “closes” the gap.
Important in this context is that a gap close does not always happen. Furthermore, the gap close does not necessarily happen right away.
I do not recommend trading gap closes on their own, but using gap fills as a way to pick targets can be beneficial. Also, once a gap is closed, you can often find re-entry opportunities because the price will return into its original direction.
When TWTR closed the gap, the price shortly after started a new bullish phase.
NFLX closed both gaps and each time, the gap close was the catalyst for a new trending move.
In Forex, gaps happen less frequently, but there is a similar mechanism we can observe. Extremely long candles often tend to get “filled” again. The price usually has an easy time reaching the origin of such long candlesticks. Below you see how the long candle on the AUDCAD got filled with another strong rejection. The price does not face any support/resistance on the way down through such a candlestick.
What’s your favorite gap type and how do you trade them? COMMENT HERE DOWN TO SUPPORT OTHERS GUYS
