Gap Trading: A Complete Guide

In gap trading, you need thorough price comparisons.

To do this, you compare the price of stocks you want to trade to see if there’s a gap between the closing and opening prices. Next, you determine the trading range of these stocks by watching their trading activity.

If the price rises above the trading range, buy them. Also, if they trade lower, it’s time to short-sell. The gap can come from so many fundamental and technical factors. For example, an earnings report can make the headlines causing the gap between the big and ask spread to widen.

Gap Types

You see these gaps when charting. Therefore, to differentiate them, check the price pattern to see if it has a stock gap down or up. These are the gaps you’ll be looking for in the chart.

Continuation Gaps

The market also calls them runaway gaps. You’ll see these gaps in the middle of a price pattern. As such, they show an increase in action by buyers and sellers who believe in the bullish or bearish pattern.

Exhaustion Gaps

You’ll note this type towards the end of a price pattern. It shows how the stock price attempted to reach new highs and lows.

Breakaway Gaps

Such a gap appears at the end of a price pattern. When you see it, it signals that a new price trend is about to begin. Thus, it seems like the former price is forming a gap away from the pattern. You can invest in breakaway gap up stocks where a high trading volume follows this gap type. Also, you can short-sell when there’s a breakaway gap down.

Common Gaps

These gaps aren’t in a price pattern. Instead, they show you where the stock price gapped. Hence, seeing them doesn’t mean there’s an opportunity to invest.

How To Trade Gaps

As you look for stocks, check the earnings calendar for a list of companies that post their earnings reports when the market closes. You can also find them when charting. You’ll see the blank spaces separating candlestick patterns. Plus, you’ll see a space preceding a green candlestick if you’re looking at the gap up opening stocks.

To trade successfully, set your entry and exit points. That way, you’ll minimize risks.

When there’s a gap up, buyers are more aggressive, meaning the market has more buy orders than the supply at the closing price. If sellers are more than buyers, the market has a stock gap down, meaning there are more orders at the opening price than the demand at the closing price the previous day.

When many traders react to fade the gap in the opposite direction, the market calls it irrational exuberance.

Volatile gap stocks are better because their prices fluctuate more. It might have you searching for stocks in volatile markets like oil and gas.

As a beginner, find a platform suited for gap trading. Consequently, look for one with a range of tools from drawing to price projection. It should also offer a range of chart types.

Gap Trading Examples

A gap appears when the price jumps suddenly. Hence, as a trader, you’ll look for a gap between the candlesticks pattern on a chart. When you trade at such points, you’re playing the gap.

For example, if a company reports higher earnings than what the market expects, you may notice a price gap in its stocks the following day. As such, the price of those stocks that day is higher than the closing price the previous day.

A real example in the market happened in 2022 with Meta stocks. These stocks ended the day at $321 and opened the following day at $248. Analysts suggested this was because of the quarterly results released by Meta. The market perceived the results as weak, which caused the low price reaction.

Let’s use this example to explain how investors react to gaps. When there are gaps in price movement, an investor can either follow or fade the gap. By following, you’ll be hoping the stock price continues in that direction, whether it’s a positive or negative gap.

On the other hand, if you decide to fade it, you work against the pattern. You enter a position that’s either bearish or bullish compared to the price trend.

Gap Trading Strategies

Learning as many strategies as possible helps you trade during different gaps.

You can have a gap trading strategy for weekly or intraday gaps. If you’re a long-term trader, understand all the gap signals. For example, the short signals can be your exit strategy to sell stocks.

One of the popular gap trading strategies is fading the gap. For example, let’s say the price starts higher than yesterday’s closing price because the company released a commendable earnings report.

During the day, as traders continue analyzing the earnings, they find some shocking facts and start selling their stocks. Hence, the price starts dropping until it reaches the previous day’s closing price. That’s how the gap fills up.

You can also enter a position by predicting the gap. To do that, analyze the technical and fundamental factors to find the probability of a price gap the following day. Many events in the market can cause such gaps.

Therefore, if you want to understand what’s happening or about to happen, keep up with the news. It means looking at various headlines, from product announcements to earning reports, senior management appointments, and upgrades or downgrades.

You can also use indicators. These include tools that show you price points.

Additionally, learn the rules of gap trading. For example, keep up with the trading volume because it can indicate a gap. When there’s a high volume, it shows a breakaway gap, while a low trading volume exhibits an exhaustion gap. Also, learn about gap types. The market recognizes four gap types, so they should be easy to draw from charts.

As with other trading strategies, you should have a way to minimize the risk as you’ll be trading in a volatile market with low liquidity.

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