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Playing the Gap: Identifying and Trading Gaps

Playing the Gap: Identifying and Trading Gaps

Courtesy of Pharmboy

Gaps are very profitable technical indicators.  A gap is an area on a chart where no trades take place and these are caused by fundamental or technical events that usually occur after the market closes and before the market opens, also known as ‘non-regular trading hours’ (NRTH’s).  There are four basic gap types:  area, continuation, breakaway and exhaustion.

Gaps are significant for many reasons:

  1. Gaps tell traders that something occurred during NRTH’s.  Typical events include: earnings announcements, FDA approvals, analyst upgrades/downgrades, company press releases and other significant events that may cause investors and traders to place orders to buy or sell during NRTH’s, causing an order imbalance.
  2. The type of gap will help you determine the probability of the stock’s direction in the short and intermediate term.
  3. Gaps are profitable.  Traders can take advantage of the imbalance of orders by either “catching the momentum” or “fading the gap”.  When riding a gap, the traders are betting that the stock will continue in the direction it gapped.  When a trader fades a gap, they are betting that the gap will “fill” and move opposite of the gap’s opening direction.

Types of Gaps

Area Gaps

Area gaps are usually small and unimportant.  They are also referred to as “common gaps” because they occur so frequently.  Characteristics of area gaps are that they are fill very quickly. When the word “fill” is used, traders are referring to the gap’s closure.  The gaps usually occur in trading ranges and they form on very low volume.  Because of the low buying volume of the stock, the gap cannot sustain itself, thus filling relatively quickly. 

The easiest way to determine if a gap will fill is to watch the first 30 minutes of the day.  If the candlesticks appear to be fading in the opposite direction, it’s very difficult to stop it.  This is because many others see the same fade and will jump on board.  Remember, a gap does not have to fill on the same day of the gap.  These types of gaps are unpredictable and are hard to trade.  Figure 59 an example of an area gap.

Figure 59.  Area gap.

Continuation Gaps

Continuation gaps are extremely important because they “continue” a trend.  They are also known as “runaway” or “measuring” gaps and they do not fill quickly.  These gaps mark a very large interest level in buying or selling a stock.  These gaps can continue an existing uptrend or downtrend and they must be accompanied by above average volume.  The reason why they are called measuring gaps is because many technicians believe that these gaps mark the halfway point of a trend.  The gaps are usually self-fulfilling prophesies as a rush of buyers or sellers get into or out of a stock anticipating additional moves in their present direction.  Figure 60 are examples of continuation gaps:

Figure 60.  Continuation gap.

Breakaway Gaps

Equally important, breakaway gaps do exactly that.  They break away from the current trend and start a new one (also known as Kickers). They can end an entire uptrend or down trend in a single day.  The characteristic of a breakaway gap is that the candle/bar must breakout from a congestion area and the volume must be extremely high.  Because these gaps start a new trend, many of these gaps do not fill for months. Figure 61 shows an example of a breakaway gap.

Figure 61.  Breakaway gaps.


Exhaustion Gaps

Just as a breakaway gap can start a new trend and a continuation gap can continue it, an exhaustion gap effectively kills the trend and marks the end of it, usually in a single day. What should happen is that a stock is in a continuous and extended uptrend (or downtrend) and the stock makes one final massive gap up (or down) and profit-taking (or a sell-off) ensues all day long. Exhaustion gaps are the most volatile of all gaps and reversals take place instantly. Whenever you see an exhaustion gap, it’s either time to sell (if you’re long) or cover (if you’re short).  Figure 62 shows an example of an exhaustion gap. 

Figure 62.  Exhaustion gap.

Strategy

Area Gaps – Day trade or short swing trade. Experienced traders should trade these gaps. Continuation Gaps – Buy during uptrend, short during downtrend (multi-week position trade). Breakaway Gaps – Trade in the direction of the gap (multi-week/multi-month position trade). Exhaustion Gaps – Sell long positions immediately, cover short positions immediately.

When to Buy (Short) and Sell (Cover)

Some traders say buy the gap. Others say wait a few days and allow it to consolidate. The higher potential risk would be the first statement and the lower risk would be the second.  Most traders should wait a few days to see if the stock consolidates normally, instead of chasing a stock.  This nearly ensures that your entry is timed correctly. 

Where are some areas where gaps occur frequently? 1) Trend lines, notably at support and resistance, 2) moving averages, and 3) breakouts (or breakdowns) from patterns.  Each area of technical analysis complements each other and so it’s necessary to use everything learned together when making a trade.

When exiting a position, it depends if the particular target is met so that the exit is voluntary or if a gap has broken down, forcing an exit.  A general rule is if a gap starts to fill, then it’s time to get out.

How to Find Trading Gaps

Instead of looking at thousands of charts a day, the best way to find gaps is to use stock screeners.  Here is the link:http://stockcharts.com/def/servlet/SC.scan . Toward the bottom of the "Technical Indicators" section, the following can be found:  Gaps up/down, runaway (continuation) gaps, and breakaway gaps, etc.  Make it a daily habit to inspect this stock screener for profitable gaps.

Conclusion

Don’t fight the general market trend.  If the market is heading lower but you see a continuation gap up in a certain stock, it’s advisable to not buy it in most cases.  As with all technical patterns, there are failures and the easiest failures come from ignoring the general market direction. Since 3 out of 4 stocks follow the market, any gaps can fade toward the direction of the market, so don’t go against the trend. 


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  1. Nice article.


  2. Nice job !~