Gap Trading

Gap trading is a popular strategy among traders that focuses on exploiting the price differences, or “gaps,” between an asset’s previous closing price and its opening price on the next trading day or session. These gaps occur when the opening price is significantly higher or lower than the prior close, creating a visible space on price charts. Understanding and trading these gaps can offer opportunities for profit, but it requires a good grasp of market behavior and risk management.

What Causes Gaps?

Gaps happen due to a variety of reasons, often linked to after-hours news, earnings announcements, geopolitical events, or significant market sentiment shifts. For example, if a company reports better-than-expected earnings after the market closes, its stock might open substantially higher the next day, creating an upward gap. Similarly, negative news may cause a gap down. These discontinuities reflect a rapid reassessment of value by the market.

Types of Gaps

There are generally four types of gaps:

1. Common Gaps – These are small gaps that occur regularly and often get filled quickly as price returns to the previous level.
2. Breakaway Gaps – These appear at the beginning of a new trend, signaling a strong move away from a consolidation zone.
3. Runaway (or Measuring) Gaps – Occur mid-trend and suggest a continuation of the current trend.
4. Exhaustion Gaps – Happen near the end of a trend, indicating a potential reversal.

Gap Trading Strategy

Traders use gap trading to capitalize on the tendency for prices to “fill the gap.” This means the price often moves back to cover the gap area before continuing its trend. The basic premise is to enter a trade anticipating that the gap will close.

The gap size can be calculated using the formula:

Gap Size = Opening Price – Previous Close Price

For a gap up, Gap Size will be positive; for a gap down, it will be negative.

A typical gap trading approach might involve waiting for confirmation that the gap is starting to fill and then entering a position in the opposite direction of the gap. For instance, if a stock gaps up but starts to show weakness, a trader might take a short position betting on a retracement.

Real-Life Example

Consider Apple Inc. (AAPL) on a day when it closes at $150.00. Overnight, it announces a major product release, and the stock opens at $155.00, creating a $5 gap up. A gap trader watches the price action closely. If AAPL starts to retreat from the $155 level and falls back towards $150, the trader might short the stock, anticipating the gap will fill. If the stock indeed drops back to $150, the trader can close the position for a profit.

Similarly, in Forex trading, if the EUR/USD pair closes at 1.1200 and opens the next day at 1.1250 after a significant economic report, the 50-pip gap can be traded with the expectation that the price will retrace some or all of this gap.

Common Mistakes and Misconceptions

One common misconception is that all gaps will fill. While gap fills are frequent, they are not guaranteed. Some gaps, especially breakaway gaps, may lead to sustained moves without filling for extended periods. Traders who blindly assume a gap will always close may incur losses.

Another mistake is neglecting the context of the gap. For example, trading a gap without considering the overall trend, volume, or news that caused the gap can lead to poor timing and entry points. It’s also crucial to use appropriate stop losses because gaps can lead to volatile price swings.

People often ask, “How to trade gap ups and gap downs?” or “What are the best indicators for gap trading?” While there is no one-size-fits-all answer, many traders combine gap analysis with volume indicators, moving averages, or candlestick patterns to confirm entries and exits.

In summary, gap trading offers a unique way to capitalize on sudden price moves between sessions. By understanding the types of gaps, their causes, and using sound risk management, traders can add gap trading as a valuable tool in their strategy arsenal.