Traders can benefit from large jumps in asset prices in volatile markets 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. The asset’s chart, on most trading platforms, shows a gapin the normal price pattern as a result. An enterprising trader can interpret and exploit these gaps for profit.
Key Takeaways
- Gaps are spaces on a chart that emerge when the price of the financial instrument significantly changes with little or no trading in between.
- Gaps can occur unexpectedly as the perceived value of the investment changes due to underlying fundamental or technical factors, such as an earnings disappointment.
- Gaps are classified as breakaway, exhaustion, common, or continuation, based on when they occur in a price pattern and what they signal.
- The price has moved back to the original pre-gap level when someone says that a gap has been filled.
Gap Basics
Gaps occur because of underlying fundamental or technical factors. A company’s stock may gap up the next day if its earnings are much higher than expected. The stock price opened higher than it closed the day before, thereby leaving a gap.
It's not uncommon for a report to generate so much buzz in the forex (FX) market that it widens the bid-ask spread to a point where a significant gap can be seen. A stock breaking a new high in the current session may open higher in the next session, thus gapping up for technical reasons.
Automated program trading such as algorithmic trading is a relatively new source of gap price action. The algorithm might signal a large buy order if a prior high is broken. The size of the algorithmic order may be such that it triggers a price gap, breaking above the recent high and drawing in other traders to the directional movement.
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 can't be placed in a price pattern. They simply represent an area where the price has gapped.
- Continuation gaps are also known as runaway gaps. They 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
The price has moved back to the original pre-gap level when someone says a gap has been filled. These fills are quite common and can occur due to three factors:
- Irrational exuberance: The initial spike may have been overly optimistic or pessimistic, therefore inviting a correction.
- Technical resistance: A price doesn’t leave behind any support or resistance when it moves up or down sharply.
- Price pattern: Price patterns are used to classify gapsand can tell you if a gap will be filled. Exhaustion gaps are typically the most likely to be filled because they signal the end of a price trend. Continuation and breakaway gaps are significantly less likely to be filledbecause they're used to confirm the direction of the current trend.
It's referred to as fading when gaps are filled within the same trading day on which they occur. Let’s say that a company announces great earnings per share for this quarterand it gaps up at the open. It opened significantly higher than its previous close.
Now let’s say that people realize that the cash flow statement shows some weaknesses as the day progresses. They start selling. The price eventually 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.
How to Play the Gaps
You can take advantage of these gaps in many ways. A fewstrategies are more popular than others.
Some traders will buy when fundamental or technical factors favor a gap on the next trading day. They’ll buy a stock afterhours when a positive earnings report is released, hoping for a gap up on the following trading day if it hasn’t already happened in after-hours trading.
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. They may buy a stock when it's gapping up very quickly on low liquidity and there's no significant resistance overhead.
Some traders will fade gaps in the opposite direction when a high or low point has been determined, often through other forms of technical analysis. Experienced traders may fade the gap by shorting the stock if a stock gaps up on some speculative report.
Traders might buy when the price level reaches the prior support after the gap has been filled.
You'll want to remember a few key things when trading gaps:
- A stock will rarely stop when it's started to fill the gap because there's often no immediate support or resistance.
- Exhaustion gaps and continuation gaps predict the price moving in two directions so be sure you correctly classify the gap you're going to play.
- Retail investors usually exhibit irrational exuberance but institutional investors and algorithmic systems may play along to help their portfolios. Be careful when using this indicatorandwait for the price to start to break before taking a position.
- Be sure to watch the volume. High volume should be present in breakaway gaps. Low volume should occur in exhaustion gaps.
Gap Trading Example
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This daily chart of Apple Inc. (AAPL) shows many gaps. This is quite normal given the propensity for equities to gap above or below the previous day’s price action when the market is closed but news is still forthcoming and filtering into the market price.
We can see a bullish engulfing line starting from the left, suggesting that the move lower may be reversing in candlestick analysis. This is followed by a bullish gap higher, further suggesting that a low is being formed. An attempt at the downside is made again but another large bullish engulfing line signals a low may have been made.
We see a bearish exhaustion gap in the center, indicating that the move higher is running out of steam and may be reversing. The gap is filled relatively quickly but it continues to act as resistance at the horizontal yellow arrow, suggesting that downside potential remains. Finally, we see a strong runaway gap indicating further upside potential on the right side amid a reversal higher.
As you can see, gaps are important price developments. They leave some in the dust and lead others to quick profits. At the minimum, gaps are important features of a security’s price action and should be monitored closely for potential trading opportunities.
What Is a Gap?
A gap occurs when the price of a security moves quickly through a price level, either up or down, with little trading or pricing available over that period.
What Causes Gaps?
Gaps can be caused by several factors but they're most often seen as the result of unexpected news or a technical breach of support or resistance. The news could be a company beating earnings estimates by a large margin or a speech by a Federal Reserve (Fed) official that impacts interest rate expectations. Gaps can ensue following the break of a prior high/low or other form of technical resistance or support, such as a key trend line.
How Can I Take Advantage of a Gap?
Gaps occur quickly and without notice, making it difficult to position in advance of a price gap. You might be lucky and long a security and it gaps higher, leaving you with a quick profit or vice versa. The other approach is to enter the market in the direction of the gap as it potentially moves to close the gap.
The gap price level/zone should provide an opportunity to get in on the directional move of the gap at a better price if the gap is sustainable.
What Happens When a Gap Is Filled and the Price Keeps Going?
It’s a strong signal that the gap was unsustainable in the first place when it's filled and later surpassed. It's also possible that news emerged indicating that the gap was in the wrong direction. You might consider taking the opposite position than the gap suggested in this case.
Let’s say a stock has gapped to the upside through a significant prior high. You might normally look to buy if the gap is filled and the breakout price level holds but you might consider the gap to be a false break if that level is surpassed to the downside. You might exit longs and take a short position following the upside rejection of the price movement.
Gaps are risky due to low liquidity and high volatility but they offer opportunities for quick profits if they're properly traded.
The Bottom Line
A gap occurs when the market price of a security jumps to another price level, either higher or lower when little if any trading has taken place. A good example is an unforeseen comment from a senior Fed official regarding the direction of interest rates. Markets may react immediately when the comment hits the newswires, with market makers pulling their bids and offers. This may cause a price gap from the last price, such as $25.20 to $26.50.
Gaps are frequently seen in the price charts of almost every security. The most frequent and significant gap in stocks occurs between the daily close and opening of the exchange. A gap may not be visible in FX markets on a one-minute chart because these markets operate 24 hours a day but would instead appear as a very long candlestick covering the gap in price. FX markets may experience gaps over the weekend between the Friday New York close and the Sunday Asia opening.
Price gaps can bedevil traders, especially if they’re on the wrong side of the gap. The most attractive trading opportunity with gaps is to go long or short as the market moves to close or fill the gap. A reasonable trade strategy would be to buy the security that has broken higher from $25.20 in a zone between $25.20 and $26.50 in case it doesn’t completely fill the gap.
It may suggest that the gap that was higher was unsustainable and that the downside remains most in play if the price eventually falls back below the breakout price of $25.20.
Disclosure: This article is not intended to provide investment advice. Investing in securities entails varying degrees of risk and can result in partial or total loss of principal. The trading strategies discussed in this article are complex and should not be undertaken by novice investors. Readers seeking to engage in such trading strategies should seek out extensive education on the topic.
