Gap Trading

Gap Trading 101:The Ultimate Guide to Gap Trading Strategies

Gap Trading

Gap trading strategies aim to capitalize on gaps in stock charts – specifically, the gaps between the previous day’s closing price and the next day’s opening price. If properly implemented, gap trading strategies can allow traders to profit from short-term price movements. This comprehensive guide covers everything you need to know about developing and executing effective gap trading strategies.

What is a Gap in Trading?

gap analysis in trading

A gap refers to an empty space or price range on a chart where no trading took place.

Gaps can form between:

  • The previous day’s close and the next day’s open (common gap)
  • The high and low prices during regular trading hours (intraday gap)

Gaps indicate trading interest and changing sentiments. They can signal new support or resistance levels, providing valuable information for technical analysis and identifying trading opportunities.

There are different types of gaps:

Breakaway Gaps

Breakaway gaps form at the start of a significant price movement, signaling the beginning of a new trend. For example, after a period of consolidation, if a stock gap is significantly higher with heavy volume, it could mark the start of an uptrend.

Runaway Gaps

These continue a trend, providing confirmation of the current direction. For instance, during an established uptrend, if a stock gaps up with expanding volume, it signals sellers are still not willing to step in despite new highs.

Exhaustion Gaps

An exhaustion gap comes after an extended move and suggests the trend may be ending soon. For example, after a prolonged uptrend, if a stock gaps significantly higher but with low volume, it could indicate the rally is running out of steam.

Common Gaps

Common gaps occur during normal market conditions due to short-term imbalances in supply and demand. For instance, low trading volume overnight could lead to a gap between the previous close and the next day’s opening. Common gaps may fill quickly.

Why Trade Gaps?

There are several advantages to trading gaps, including:

  • High success rate – Statistics show gap trading strategies have win rates of over 70%.
  • Defined risk – Many gap trades utilize stop-losses, defining maximum loss levels.
  • Quick profits – Gaps react quickly, allowing position entries and exit within minutes to hours.
  • Technical significance – As mentioned earlier, gaps signify changing market sentiments that can fuel new trends.

When a stock gap up or down, there has been a significant change in valuation or outlook – gap trading aims to capitalize on just these situations.

Gap and Go Trading Strategies

Gap and go trading strategies are a popular method to trade gaps. They aim to enter positions quickly after the gap occurs, profiting from the initial impulse.

There are two main types:

Gap and Go Long

This strategy goes long after stock gaps are significantly higher at market open. The gap signals renewed optimism, while increased volume provides confirmation.

A stop-loss order is placed below the low of the gap bar. Profit targets are set at the next resistance level or using a risk-reward ratio like 1:2.

If the stock moves higher as expected, the position is exited for a profit. If not, the stop-loss triggers, minimizing any loss.

Gap and Go Short

This strategy shorts a stock after it gaps significantly lower on heavy volume. The gap indicates increased pessimism about the stock’s prospects.

A stop-loss order is placed above the high of the gap bar to control losses. Profit targets are set at the next support level or a risk-reward ratio like 1:2.

If the stock drops as expected, profits are taken. If not, the position is closed at a small loss based on the stop level.

Other Gap Trading Strategies

In addition to the gap and go approaches, there are several other gap trading tactics to consider:

Fading the Gap

This contrarian strategy fades or goes against the gap by entering limit orders on the other side of the gap. The aim is to profit when the stock reverses and fills the gap as excessive movements revert back to the mean.

For example, if a stock gap is significantly higher but with low volume, suggesting a lack of commitment behind the move, fade traders will go short, expecting the gap to be filled.

Intraday Gap Trading

Intraday gap trading strategies target temporary price voids that form during regular trading hours, fading moves, and overextended moves for mean reversion plays.

For instance, if an uptrend pause and selling pressure pushes the stock down quickly, creating a sizeable gap within the day’s price range, intraday traders will go long, expecting the gap to be filled and the uptrend to resume.

Gap Continuation Strategies

These approaches assume the move behind the gap will continue, establishing positions in the same direction. Continuation trades can utilize various indicators and chart patterns to confirm the gap signals.

For example, after a breakaway gap higher backed by increasing volume, suggesting a new uptrend, continuation strategies will go long on retests of the gap as new support or on bull flags, expecting further upside. Stop below the recent swing low or moving average.

Tips for Trading Gaps

When developing your own gap trading strategy, keep these tips in mind:

Confirm the Gap

Do not trade all gaps. Confirm them by checking if the gap is backed by heavier than usual volume, signaling strong conviction behind the move. One can also wait for continuation patterns like flags, wedges, or retests of the gap as fresh support/resistance.

Define Stop Levels

Use stop-loss orders on all trades. Logical stop areas include below/above the gap bar low/high, under/over moving averages, or recent swing lows/highs. This will control potential losses.

Set Profit Targets

Set upside/downside profit targets at the next resistance/support level, the previous day’s high/low, or use a risk-reward ratio like 1:1.5 or 1:2. Scaling out of positions at multiple targets can allow for greater profits.

Be Selective

Not all gaps provide trading opportunities. Focus only on breakaway, runaway, and exhaustion gaps with above-average volume. Use technical analysis to confirm signals. Ignore common gaps with low interest.

Check Overall Context

Examine the broader technical picture when trading gaps. For example, fading a gap against a long-term uptrend is usually riskier than trading in the prevailing direction.

Conclusion

Gap trading aims to profit from the significant price voids that form overnight or during trading sessions. Strategies like gap and go establish positions quickly after gaps occur, while other approaches fade or continue gap moves. Specific entry, exit, and risk management rules are vital. With the proper guidelines, gap trading can provide well-defined, high-probability trades. This overview covers the key concepts needed to design and implement effective gap trading strategies.

Common Questions about Gap Trading

Here are answers to some frequently asked questions about gap trading:

How often do gaps fill?

Statistics indicate gap trading strategies have a win rate of over 70%. However, proper trade planning, analysis of volume patterns, and use of stop-losses improve outcomes.

Do gaps fill the same day?

Yes, gaps often fill intraday, but they can also take several days to close. Day trading gap strategies typically focus on same-day gap reversals. Swing trading approaches hold for gap fills over the next few days.

What is the best gap trading strategy?

The most profitable gap system depends greatly on a trader’s style. Many find breakaway gaps offer reliable trades in the direction of the emerging trend. Exhaustion gaps also provide opportunities, fading overextended moves.

What gaps are best to trade?

Focus on breakaway, runaway, and exhaustion gaps with above-average accompanying volume. Use technical analysis to confirm signals. Avoid illiquid stocks and common gaps with low interest.

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