Don’t you just hate it when you hold a bullish trading position overnight, but the market opens down, turning your profits into losses?
We’ve all been there.
This phenomenon is called a gap, it happens when there is a difference between the closing and the opening price.
The good news is that there are successful gap-trading strategies for entering and exiting the markets. They will help you take advantage of price behavior, and improve your trading success. Keep reading and you’ll find out everything there is to know about gaps.
Can you see gaps in every market?
Because the Forex market is open around-the-clock, gaps often only appear on Sunday evenings when the market opens. On the other days of the week, the FX market trades continuously.
Gaps are more common on the stock market and usually appear in the morning. Because European, American, Japanese, and other exchanges have a different fixed opening and closing times, gaps occur on indices and stocks when there are a large number of accumulated orders during these times.
Which kind of charts should you use to better spot gaps? There are several different types of charts provided by your broker, such as:
- Point & Figure (P&F) charts
- Renko charts
- Heikin Ashi charts
- Kagi charts
Traders mostly use line charts, bar charts, and candlestick charts. As a gap is a price difference between two trading days, it’s essential to use bar charts, or candlesticks charts – as line charts only display closing price connected by a straight line.
In this article, we will use candlestick charts, as they help present the function of the gaps by adding qualitative information about the underlying movement, as well as its future evolution.
Let’s say that a bullish gap appears while exiting a range with a long candle with no shadow (marubozu candle). This will be a stronger trading signal than if the gap appears with a doji, which is an indecision pattern.
The Different Types of Gaps
As a technical analyst, you are looking either for signs of change in market dynamics, or for signs of current trend confirmation. If a market is going up, you could look at signs to enter the market to follow the main direction.
But you could also look at signs showing that the trend is about to reverse. The same applies to a bearish market.
When a market is rangy, then you are looking for a change in the current market participants’ behavior, which could lead to a breakout to the upside, or the downside. If you spot these changes, you will make more profitable trades by entering the trend early, riding it, and exiting it once it’s over.
And the best part?
Gaps are a good tool to spot these changes.
Bullish vs Bearish Gaps
A bullish gap happens when the close of the previous day is lower than the opening of the following day. A bearish gap happens when the close of the previous day is higher than the opening of the following day.
These gaps usually show a change in the psychology of the market, so they appear after a consolidation phase. It means that they are gaps in price over a significant level, such as support or resistance lines, which triggers a new trend.
For this reason, when there is a gap at the beginning of a trend, you can consider it to be a breakaway gap.
In the example above, we can see that after a lateral consolidation, where prices had trouble reaching the lower part of the range for many days, the DAX index exited the range with a bullish breakaway gap.
This gap confirmed the upcoming bullish movement.
These gaps usually show confirmation of the current market trend, even though you can see minor corrections. It’s for this reason that this kind of gap is often called a continuation gap. If the market is up, then the runaway gap will be a bullish one. On the other hand, of the market is down, then the runaway gap will be a bearish one.
Runway gaps usually appear in the middle a trend, which helps traders to anticipate the growth potential of a position. You won’t be surprised then if I tell you that another name for the runaway gaps are measuring gaps.
The above chart shows a runaway gap within a bearish movement. The 1st black arrow displays the distance from the beginning of the movement to the runaway gap. This distance has been projected above the gap to get a target price – this is the 2nd black arrow. You can see at the bottom of the chart that there was a high amount of trading volume at the same time, which confirms the strength of the gap.
As this name suggests, these kinds of gaps appear at the end of a trend. However, they do not give any information about another trend starting.
It’s often difficult to distinguish between a runaway gap and an exhaustion gap, as prices could reverse immediately, or enter into a congestion zone for a while. However, the exhaustion gap shows usually the last movement in the direction of a current trend before finally reversing.
If prices reverse, then it means that this gap is filled. Filling a gap means that prices have come back to the same level before the gap. An exhaustion gap is the kind of gap that is filled faster.
Why Do Gaps Appear?
A gap is like an “emotional moment” on the markets where there are no transactions. It occurs when markets conditions at market close aren’t the same as when they open. Gaps represent a change in market participants’ psychology, and often reflect future support and resistance zones that prices come to test several times.
There are many potential causes for gaps:
- A lack of market interest with lower liquidity and volume,
- A great interest from market participants with high liquidity and volume,
- An important piece of political, or economic news,
- M&A news,
- Earnings reports,
- Central banks’ decisions,
- Natural disaster,
- Terrorist attacks,
The most important thing isn’t to understand why a gap appears, but how markets are going to react to it. You can study the price movement, the volume and the size of the gap in order to determine better entry and exit points.
By now you will have realized that the size of the gap provides information about the strength behind this movement. A big gap with a large trading volume will be stronger than a smaller one with low volume.
Which kind of trading style works best with gap trading?
Using a price gap suits swing trading and day trading styles best. Scalpers target profits made in a very short-term time frame within a single trading day, so it is not optimal with gap trading, which is better for trend traders.
Let’s now have a look at strategies you can use when a gap appears.
Gap Trading Strategies Can You Use
The most interesting type of gap to use while trading gaps is the breakaway one, as it announces a new trend.
This trend reversal signal should be used to enter the market in the direction of the gap, which is very rarely filled. Using this gap is a great swing trading opportunity. If you missed the breakaway gap, you can also enter the market with the runaway gap that confirms the strength of the trend.
Short-term traders can also use common gaps to get an idea of the daily market’s psychology and take advantage of it. Intraday gap trading can work for these traders and will minimize risks, as there are no overnight positions.
When the day starts with a bullish gap followed by another price increase, like on the above 5 min chart, you can enter the market with a long position. You also need to be sure that the trading volume is high when the gap occurs.
The same applies when it’s a bearish gap.
When the day starts with a bearish gap, prices bounce back. They end up filling the price until a reversal pattern occurs, where you can enter the market with short positions.
The same applies when it’s a bullish gap.
Gap analysis should always be used in conjunction with sound money management rules
Trailing stop-loss orders could easily be placed below the lowest level of the last candle of the previous day in case of a bullish gap, or above the highest level of the last candle in case of a bearish gap. Regarding take profit orders, you can use simple technical analysis tools and candlesticks chart pattern to decide where to place them.
There are many ways to take advantage of gaps. Traders who can correctly identify a different kind of gaps will have an edge over those who can’t. You should remember that trades must be in the overall direction of prices and that volume should be higher than usual when gaps happen.
So, are you ready to use gaps in your trading?
The Smart Investor content is intended to be used and must be used for informational purposes only. We are not an investment advisor and you should NOT rely on this information to make investment decisions.