Gap trading is a simple approach to trading various market instruments. Traders can analyze them on charts and accordingly make their moves.
Traders invest with the motive to make huge profits, but as the markets are volatile, it becomes difficult. These create gaps in the price of the assets, and traders try to find an opportunity in these to earn money.
To enhance readers’ knowledge of gap trading strategy and what it looks like, we have detailed information to trade.
What is Gap Trading?
To begin with, let’s understand the concept of gap trading step by step. Consequently, we’ll first know what a gap is and then move to gap trading and its aspects.
A gap is an area that is depicted on charts and involves no trading activities. Readers should know here that the gap is shown when the price of the asset moves cleanly high or low, but there is no trade or movement in between.
We can take it in this manner suppose the last closing price of an asset was at a low price and its opening price for the next day has a sudden jump. So, the gap between the previous day’s close and today’s opening is the gap.
No trading activity for the particular asset is called gap trading or gapping. Traders can make good investments out of these situations and have ample opportunities to trade.
Why do gaps occur?
A gap is a market situation that occurs significantly due to a number of technical and fundamental factors.
For example, a company’s shares are traded at a price of $50 per share, and the next morning it had a share price of $40 because of the company’s policies being upgraded. Similarly, there could be other fundamental aspects that traders can check affecting their assets.
These gaps can move the market in either market direction when a gap is created. This has many small to big reasons such as product introduction, the appointment of new staff, industry policies, economic changes, etc.
When a full gap is upwards when the price of the asset traded is high in comparison to the closing price. While the downward full gap is when there is a fall in the price of the asset compared to the closing price.
Classification of Gaps
Gap trading is a unique trading strategy of the financial markets, and it is generally grouped into four classes. These include:
- Breakaway gaps
- Exhaustion gaps
- Common gaps
- Continuation gaps
These main types of gaps are dependent on their occurrence on the charts. Therefore, it is highly important to know where the gap shows up on the charts. Let’s have a brief introduction to these groups of gaps.
The breakaway gap is a signal of new beginnings in the market. This gives traders an idea that a new trend is going to start, and it is used as an opportunity. The breakaway gap occurs at the end as obvious, and the assets gap away from the price pattern followed.
These breakaway gaps trigger a breakout in the market and are accompanied by a high volume of trade. Traders can consider it for long position trading when breakaway up and short trade when breakaway down.
The exhaustion gap occurs at the end of the price pattern and signals the last attempt to reach new highs or lows in the trade. It is conversely to the continuation gap trading. The price of the asset creates the final gap in the market trend, and then it reverses.
Traders of exhaustion gap have a belief that it is the last trend direction, and they move the asset into the overbought situation to trade. Experienced traders watch the market for reversal and take opposite positions before the trend occurs.
The common gap is simple and shows the gap created in price action independent of the price patterns and has no opportunities for traders. So, these are not placed in price patterns and represent the area where the gap has taken place.
Continuation/ Runaway Gaps
Runaway gaps are the acceleration of the existing bullish and bearish patterns in the same direction. The gap trading is the result of news events confirming sentiment and moving the trend.
Traders find this a good opportunity to trade and follow the market trend. They place a stop below the gap for the bullish runaway gap and above the gap for a bearish runaway gap trading.
The pattern occurs in the middle of the price pattern with a signal of the rush of the buyers and sellers. The traders of the runaway gap trading have to believe in the asset’s future direction.
Understanding the Gap Fill
Gap-fill is a market situation that happens when the price of the asset returns to its original value before the gap trading occurs.
In gap fill, the price action happens in the following days or weeks and retraces a day before the gap. The gap fill is impacted by various factors listed below:
- Price corrections
- Support and resistance levels
These are three significant factors that affect the gap fills; the price corrections is the optimistic and pessimistic initial spike in the price that may have corrections. While the support and resistance level is present in the trade when the price moves sharply.
The price patterns show the willingness of the gap to be filled. All these together make the gap fill in the gap in the trading strategy.
In simple words, when there is a gap fill, it means that the price of the asset has moved back to its original gap level. The gaps usually get filled within a day. This is what we call the gap-fill strategy.
Gap Trading Strategies
Gap has several gap trading techniques that traders use to explore the asset traded. These help traders analyze the fading and predict gaps, and apply indicators to gauge the price trend.
Here, we have these gap trading strategies discussed below for in-depth understanding:
Fading the Gap
Fading the gap is the gap trading strategy that means to fill the gap. It takes place when the gaps are filled within the day they occur.
For example, the stock gaps at the opening price that is higher than its previous close. Eventually, the industry sees changes in its operation within the day, and the price gap is filled or faded.
Predicting the Gap
Predicting the gap is necessary for traders to have good profits from their investment. They have to check with the fundamental and technical analysis and know the potential gains. With this, they can enter or exit the position.
Indicators are part of the gap trading strategies as they guide traders to ascertain the changes and find good opportunities. Traders can go for tools such as exponential moving average, relative strength index, or others to make informed decisions. You can use all these indicators in favorable conditions with the top brokerage firm Investby.
Here, traders can use the various gap trading types to understand the financial instrument price patterns. Exhaustion gap or any other could be used for trading or even the factors such as earnings reports are used to analyze the price movements.
The most important of all is the prior day’s close and the opening price gap of the instruments. This helps to get the future results from the investment advice from the gap created and used trading strategy.
Some other Gap strategies
- When trading in the stock, when there is a rally in price in a downtrend, this provides traders with great opportunity. They can short sell the stock in the market and earn profits.
- The gap-up stock in the uptrend offers the opportunity to buy and hold the shares for a long period.
- A gap down in stock is a decline in the price in the upward trend and has the opportunity to buy.
- The gap-down stock in a downtrend provides an opportunity to short sell in the market.
Gap Trading Rules
The gap trading system is unique and has key things that traders can consider while trading in the market. Below mentioned are the rules:
- Gap classification is the first thing that traders should do. They can know out of the four gaps which one they have in the market and accordingly react or take a step.
- When the gap starts to fill, it hardly stops because of the no immediate support and resistance.
- The volume of the trade is of high significance as gaps are normally high volume in the breakaway and low volume in exhaustion.
- Amateur traders exhibit irrational energy, which sets the exhaustion gaps; they wait for the price to break before taking a position.
- Trading in gaps means trading at high volatility, be it stock or other assets. In stock gaps, there is low liquidity. So, traders have to be careful while trading and use proper indicators and tools to manage risks.
In gaps, the market volatility makes it difficult for traders to make money. However, if traders are well aware of the prospects surrounding it, they can have good trading.
The article has covered all the areas that relate to the topic and that traders should be aware of while trading in gaps or using the trading strategy.
Price charts are necessary for gap traders as they study the opening price and closing on them. Therefore, price chart reading is vital for correct prediction and trading strategy. Applying such a trading strategy requires complete knowledge and analysis of the market.
Thus, traders should be careful and try and make the best of the opportunities present.