$LLOY : Lloyds Banks UKIn volatile markets, traders can benefit from large jumps in asset prices, if they can be turned into opportunities. 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. This article will help you understand how and why gaps occur, and how you can use them to make profitable trades.
Gap Basics
Gaps occur because of underlying fundamental or technical factors. For example, if a company's earnings 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.
Gaps can be classified into four groups:
Breakaway gaps occur at the end of a price pattern and signal the beginning of a new trend.
Exhaustion gaps occur near the end of a price pattern and signal 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 has gapped.
Continuation gaps, also known as runaway gaps, occur in the middle of a price pattern and signal a rush of buyers or sellers who share a common belief in the underlying stock's future direction.
To Fill or Not to Fill
When someone says a gap has been filled, that means the price has moved back to the original pre-gap level. These fills are quite common and occur because of the following:
Irrational exuberance: The initial spike may have been overly optimistic or pessimistic, therefore inviting a correction.
Technical resistance: When a price moves up or down sharply, it doesn't leave behind any support or resistance.
Price Pattern: Price patterns are used to classify gaps and can tell you if a gap will be filled or not. Exhaustion gaps are typically the most likely to be filled because they signal the end of a price trend, while continuation and breakaway gaps are significantly less likely to be filled since they are used to confirm the direction of the current trend.
When gaps are filled within the same trading day on which they occur, this is referred to as fading. For example, let's say a company announces great earnings per share for this quarter and it gaps up at the open (meaning it opened significantly higher than its previous close). Now let's say, as the day progresses, people realize that the cash flow statement shows some weaknesses, so they start selling. Eventually, the price hits 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 high.
