How to play the gap

Traders can benefit from large jumps in asset prices in volatile markets 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 in between. The asset’s chart shows a gap in the normal price pattern as a result. An enterprising trader can interpret and exploit these gaps for profit.

Gap Basics

Gaps arise due to underlying fundamental or technical factors. A company’s stock may depreciate the next day if its earnings are much higher than expected. The share price opened higher than it closed the previous day, thus leaving a gap.

It is not uncommon for a report to generate so much buzz in the forex (FX) market that it widens the bid-ask spread to a point where a significant gap can be seen. A stock that breaks a new high in the current session may open higher in the next session and thus go for technical reasons.

Automated program trading such as algorithmic trading is a relatively new source of gap price action. The algorithm can signal a large buy order if a previous high is broken. The size of the algorithmic order can be such that it creates a price gap, which breaks above the recent high and draws other traders to the directional movement.

Gaps can be classified into four groups:

Breakout gaps occur at the end of a price pattern and indicate the beginning of a new trend. Exhaustion gaps occur near the end of a price pattern and indicate 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 gapped. Continuation gaps are also known as runaway gaps. They occur in the middle of a price pattern and indicate a rush of buyers or sellers who share a common belief in the underlying stock’s future direction.

To fill or not to fill

The price moved back to the original pre-gap level when someone says a gap has been filled. These fillings are quite common and can occur due to three factors:

Irrational exuberance: The initial rise may have been overly optimistic or pessimistic, thus inviting a correction.
Technical resistance: A price leaves no support or resistance when it moves sharply up or down. Price Pattern: Price patterns are used to classify gaps and can tell you whether a gap will be filled. Exhaustion gaps are typically the most likely to be filled because they signal the end of a price trend. Continuation and breakout gaps are significantly less likely to be filled because they are used to confirm the direction of the current trend.

This is referred to as fading when gaps are filled within the same trading day on which they occur. Let’s say a company announces big earnings per share for this quarter and opens it up. It opened significantly higher than its previous close.

Now let’s say that people realize that the cash flow statement shows some weaknesses as the day progresses. They start selling. The price finally reaches 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 peak.

How to play the gaps

You can take advantage of these gaps in many ways. A few strategies are more popular than others.

Some traders will buy when fundamental or technical factors favor a gap on the next trading day. They will buy a stock after-hours when a positive earnings report is released, hoping for a gap on the next trading day if it hasn’t already happened in after-hours trading.

Traders can also buy or sell in highly liquid or illiquid positions at the beginning of a price movement, hoping for a good fill and a continuing trend. They can buy a stock when it rises very quickly due to low liquidity and there is no significant resistance overhead.

Some traders will blur gaps in the opposite direction when a high or low has been determined, often through other forms of technical analysis. Experienced traders can blur the gap by shorting the stock as a stock gaps on a speculative report.

Traders can buy when the price level reaches the previous support after the gap is filled.

You’ll want to remember a few important things when trading gaps:

A stock will rarely stop when it begins to fill the gap because there is often no immediate support or resistance. Exhaustion gaps and continuation gaps predict the price to move in two directions, so make sure you correctly classify the gap you are going to play. Retail investors usually show irrational exuberance, but institutional investors and algorithmic systems can work together to help their portfolios. Be careful when using this indicator and wait until the price starts to break before taking a position. Be sure to keep an eye on the volume. High volume must be present in breakout gaps. Low volume should occur in exhaustion gaps.

Gap Trading Example

This daily chart of Apple Inc. (AAPL) shows many gaps. This is quite normal given the tendency for stocks to gap above or below the previous day’s price action when the market is closed, but news is still on its way and filters into the market price.

We can see a bullish engulfing line starting from the left, which suggests that the move may reverse lower in candlestick analysis. This is followed by a bullish gap higher, which further suggests that a low is forming. An attempt to the downside is made again, but another large bullish engulfing line indicates that a low has been made possible.

We see a bearish exhaustion gap in the middle, indicating that the move higher is running out of steam and may reverse. The gap fills relatively quickly, but it continues to serve as resistance at the horizontal yellow arrow, indicating downside potential remains. Finally, we see a strong runaway gap indicating further upside potential on the right amid a reversal higher.

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

The Bottom Line

A gap occurs when the market price of a security jumps to another price level, either higher or lower when little if any trading has taken place. A good example is an offhand comment from a senior Fed official about the direction of interest rates. Markets can react immediately when the comments hit the newswires, with market makers pulling their bids and offers. This can cause a price gap from the last price, such as $25.20 to $26.50.

Gaps are frequently seen in the price charts of almost every security. The most common and significant gap in stocks occurs between the daily close and open of the stock market. A gap may not be visible in FX markets on a one-minute chart because these markets operate 24 hours a day, but will instead appear as a very long candlestick that covers the gap in price. FX markets may experience gaps over the weekend between the Friday New York close and the Sunday Asia open.

Price gaps can spoil traders, especially if they are 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. A reasonable trading strategy would be to buy the security that broke above $25.20 in a zone between $25.20 and $26.50 in case it does not completely fill the gap.

This could indicate that the gap higher was unsustainable and that the downside remains most in play if the price eventually drops back below the breakout price of $25.20.

Disclosure: This article is not intended to provide investment advice. Investing in securities involves varying degrees of risk and may result in partial or total loss of principal. The trading strategies discussed in this article are complex and should not be undertaken by novice investors. Readers who wish to engage in such trading strategies should seek extensive training on the subject.