Gaps are areas on a chart where the price of a stock (or another financial instrument) moves sharply up or down, with little or no trading in between. As a result, the asset's chart shows a gap in the normal price pattern. The enterprising trader can interpret and exploit these gaps for profit.
Gaps occur because of underlying fundamental or technical factors. For example, if a company's are much higher than expected, the company's stock may gap up the next day. This means the stock price opened higher than it closed the day before, thereby leaving a gap. In the forex market, it is not uncommon for a report to generate so much buzz that it widens the bid and ask spread to a point where a significant gap can be seen. Similarly, a stock breaking a new high in the current session may open higher in the next session, thus gapping up for technical reasons.
How to Play the Gaps
There are many ways to take advantage of these gaps, with a few strategies more popular than others. Some traders will buy when fundamental or technical factors favor a gap on the next trading day. For example, they'll buy a stock after hours when a positive report is released, hoping for a gap up on the following trading day. Traders might also buy or sell into highly liquid or illiquid positions at the beginning of a price movement, hoping for a good fill and a continued trend. For example, they may buy a currency when it is gapping up very quickly on low liquidity and there is no significant resistance overhead.
Some traders will fade gaps in the opposite direction once a high or low point has been determined (often through other forms of ). For example, if a stock gaps up on some speculative report, experienced traders may fade the gap by shorting the stock. Lastly, traders might buy when the price level reaches the prior support after the gap has been filled. An example of this strategy is outlined below.
Here are the key things you will want to remember when trading gaps:
∙ Once a stock has started to fill the gap, it will rarely stop, because there is often no immediate support or resistance.
∙ Exhaustion gaps and continuation gaps predict the price moving in two different directions – be sure you correctly classify the gap you are going to play.
∙ Retail investors are the ones who usually exhibit irrational exuberance; however, institutional investors may play along to help their portfolios, so be careful when using this indicator and wait for the price to start to break before taking a position.
∙ Be sure to watch the . High should be present in breakaway gaps, while low should occur in exhaustion gaps.