Gap trading: how to use gap trading strategies

Price gaps occur regularly in markets – especially stocks – which makes gap trading an important phenomenon to understand. Discover trading strategies for exhaustion gaps, breakaway gaps and more.

What is a gap?

A gap is an area on a price chart where the price of an instrument – usually a stock – moves sharply up or down with no trading in between. This means that there is a ‘gap’ in the price pattern.

Gaps typically occur at the start of a trading day, when the market opens above or below the previous close due to news breaking overnight.

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Gap up vs gap down

Gap up and gap down describe the price movement of the break in the chart.

A gap up occurs when the new candlestick opens above the close of the previous candlestick.

And a gap down occurs when the new candlestick opens below the close of the previous candlestick.

These gaps can be a cause for concern for traders, as they can lead to orders not being executed at the desired price. For example, if a stop loss is set at a level of 100, but the market gaps from 101 to 99, the order would have to be executed at 99 – creating more loss.

That’s why a lot of traders choose to use guaranteed stop-loss orders (GSLOs), which will close at their desired level regardless of market gapping. They’re free to attach but will cost a small fee if executed.

But gaps can also be exploited for profit. To understand how to trade gaps, we first need to know why they happen.

Why do markets gap?

A market will experience a gap if the perceived value of the underlying instrument changes unexpectedly. This is most common around breaking news or earnings results that differ hugely from analyst expectations.

There are four types of gaps that can occur:

1. Exhaustion gaps signal a market is about to reach the end of a pattern, and there’s a final burst of momentum toward new highs or new lows
2. Breakaway gaps signal a price pattern has ended and a new trend is forming
3. Continuation or runaway gaps occur in the middle of a price pattern and signal a rush in demand. These are usually caused by news confirming the existing market sentiment, whether it’s bullish or bearish
4. Common gaps are found outside of a typical price pattern. As the name suggests, this type of gap occurs regularly but it’s usually an indication of a lack of interest in the stock, rather than a trading opportunity

What does ‘fill the gap’ mean?

To fill the gap, or a gap being ‘filled’ means that the price has reverted to the original, pre-gap price. It is common for this to happen, but it can take days or weeks.

Ultimately, fills depend on:

• Price patterns – if a gap is part of a known pattern, it can indicate whether it will be filled or not. For example, if it’s a continuation gap, it’s less likely to be ‘filled’ as it signals the current trend will continue, not reverse
• Sentiment – the initial gap is usually caused by a sudden change in market opinion, whether it’s optimism or pessimism. The price filling will occur when the news has been disseminated and digested by the market
• Technical levels – when a price moves quickly, there is often no immediate support or resistance. Eventually, these exhaustion points will be found, and the market will steady itself

If the gap is filled on the same day, it’s known as ‘fading’. Common gaps and exhaustion gaps are usually the quickest to be filled.

Gap trading strategies

When you’re trading a gap, you’re not trying to take a position in advance – as gaps occur too quickly and without much warning – instead, you’ll be anticipating what happens afterwards.

Let’s look at a couple of ways traders use gaps to their advantage.

Gap-and-go trading strategy

The gap-and-go strategy is the basis for pretty much every gap trade there is because you just do what the name suggests: find a gap and enter a position. The position you’ll take will depend on which type of gap has occurred.

For example, since common and exhaustion gaps are more likely to return to their original price quickly – i.e., ‘fade’ – traders will usually be looking to take a very short-term position that the market will head in the opposite direction from the gap.

So, if a stock had gapped up, they’d expect it to correct back to the lower price, opening a short position to take advantage of the correction. Whereas if a stock had gapped down, they’d take a long position to benefit from the bounce back higher.

However, if a trader believes they have identified a breakaway or runaway gap, they’d look to open a position in the same direction as the gap up or down, ready to benefit from the trend.

Earnings gap analysis strategies

Typically, stocks will experience gaps around earnings season when there are a lot of fast, irrational reactions to the news. So, day traders will look to find potential opportunities to benefit from misinterpretations of earnings results. 

For example, let’s say a company announces better-than-expected earnings per share. When the market opens, it gaps up as buyers flood the market. But as the day progresses, and investors start to digest the rest of the report, weaknesses are identified.

This leads to selling, and eventually, the price returns to the previous close. The gap has been filled.

Keen-eyed gap traders will look to find stocks where the market gets carried away with itself before correcting.

For those looking to enter longer-term positions after earnings, it can be worth waiting to confirm a price trend before taking a position, or you may get caught up in gaps filling.

Volume trading strategies

Volume is a key part of some gaps, so is an important indicator for anyone looking to create a gap trading strategy.

Breakaway gaps normally exhibit high volume both before and after the gap itself, as more traders rush to take their positions in the trend. So, if the stock gaps up and the volume is also high, it can be a sign that the stock has further to go on the upside.

Exhaustion gaps are more likely to see low volume, as the market enters overbought or oversold territory and reverses.