Trading Gaps Mastering the Gap Trading Strategy in 2023

what is gap trading

Each of the four gap types has a long and short trading signal, defining the eight gap trading strategies. The basic tenet of gap trading is to allow one hour after the market opens for the stock price to establish its range. A Modified Trading Method, to be discussed later, can be used with any of the eight primary strategies to trigger trades before the first hour, although it involves more risk. Once a position is entered, you calculate and set an 8% trailing stop to exit a long position, and a 4% trailing stop to exit a short position. A trailing stop is simply an exit threshold that follows the rising price or falling price in the case of short positions. In order to successfully trade gapping stocks, one should use a disciplined set of entry and exit rules to signal trades and minimize risk.

To sum up, trading gaps is a great strategy that can be highly profitable if well mastered. Occasionally, it may take days, weeks, and even months until the gap is filled. However, I don’t think I’ve seen many cases in which a price gap was not filled (unless the asset is illiquid and there’s low volume). So, adding this ‘trick’ to your tool kit and applying it to your trading routine could be extremely useful.

what is gap trading

On the fundamental side, the news could be a company beating earnings estimates by a large margin, or a speech by a Federal Reserve (Fed) official impacting interest rate expectations.

It reveals where a long position is entered in response to increased trading volume following the gap, and a possible initial stop loss level to protect against the higher risk. Price charts can reveal a wealth of information about a stock’s price history and potential future direction. By understanding common price patterns and trends, you can make more informed trading decisions.

Examples of a Stock Gap

Patterns like ‘Breakouts’ and ‘Breakdowns’ often occur around areas where a price gap exists. A breakout gap happens when the stock price moves outside its typical trading range, often accompanied by high volume. The good thing is that in trading, you can use this gap to find profitable trades. Unlike off-the-market products, instruments traded in financial markets are viewed in different timeframes on price charts. Price gaps are simply areas on a price chart where there’s no trading activity, and the asset’s price either rises or falls from the previous candle’s closing price.

Traders should always be aware of the liquidity of the instrument they are trading, as it affects the ease with which positions can be opened and closed without significant price impact. It’s also important to keep a close eye on ‘Interest Rates’ and announcements from the ‘Federal Reserve’ (Fed), as these can significantly influence market sentiment and cause price spikes or corrections. Diversification across different securities and asset classes can help spread risk, reducing the impact of adverse movements in any single investment. One key aspect is understanding and managing ‘Margin Requirements’ – essential for traders who use leverage. From my experience, setting clear ‘Stop Losses’ and ‘Price Targets’ is a fundamental practice that helps in mitigating risks.

what is gap trading

He is a CFA charterholder as well as holding FINRA Series 7, 55 & 63 licenses. He currently researches and teaches economic sociology and the social studies of finance at the Hebrew University in Jerusalem. This is for informational purposes only as StocksToTrade is not registered as a securities broker-dealer or an investment adviser. Gaps are risky—due to low liquidity and high volatility—but if properly traded, they offer opportunities for quick profits. Gaps can be caused by several factors, but they are mostly seen as a result of unexpected news or a technical breach of support or resistance. From my experience, in the vast majority of cases, when the asset starts filling the gap, the price will go down until the point it fills the entire region.

What is a gap?

On the technical side, 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. Starting from the left, we can see a bullish engulfing line, suggesting the move lower may be reversing (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.

Logically, the best markets to trade gaps are those with opening and closing hours. This way, you can use a pre-market scanner to find gaps and utilize this strategy for the first 30 minutes to 1 hour following the opening. While spotting gaps does not require special trading skills, learning how to trade them could be quite a challenge.

  1. If you are keen to learn more about the gap trading strategy, along with many other trading strategies, we suggest you join our trading academy.
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  3. Gaps are risky—due to low liquidity and high volatility—but if properly traded, they offer opportunities for quick profits.
  4. On the fundamental side, the news could be a company beating earnings estimates by a large margin, or a speech by a Federal Reserve (Fed) official impacting interest rate expectations.
  5. On the other hand, in the second and third scenarios, once the price gap was filled, the market reversed.

Exhaustion gaps occur near the end of a price trend and signal that the trend is coming to an end. By definition, 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. For example, if a company’s earnings are much higher than expected, then the company’s stock may gap up the next day.

This largely occurs following major news events or economic announcements affecting the stock market. A full gap, for example, can indicate strong buyer enthusiasm and a potential upward trend, which can create a buying opportunity. Conversely, a full gap down might suggest heavy selling pressure, indicating a potential downward trend and an opportunity to short-sell the stock.

Market Opening Gap Strategy: Harnessing Early Movements

Some market participants also have their own unique approach to trading gaps, which may encompass elements of the aforementioned strategies. Gap trading therefore relies on the belief that gaps on price charts represent opportunities for profit. Investors and traders embracing this philosophy often utilize the steps/considerations outlined below when deploying a gap trading approach. Support levels are price levels at which a stock has historically had difficulty falling below, while resistance levels are levels that a stock has had difficulty rising above. If a price gap causes a stock to break through a support or resistance level, it could signal a potential trading opportunity. A full gap happens when the opening price of a stock significantly deviates from the previous day’s high or low price.

How Often Do Stocks Gap?

Therefore, not all traders have the skills or the nerves to enter the market when it’s choppy and risky. The solution is to wait for the noise to disappear before making any trading decision. Simply put, the Gap Trading Strategies are rigorously defined trading systems that use specific criteria to enter and exit trades. Paper trading is the simplest method for successfully determining your ability to trade gaps. Instead, write down or log your entry signal, then do the same for your exit signal. After this, subtract your commissions and slippage to determine your potential profit or loss.

When looking for a gapping stock, it’s important to note that there are three types of gaps that you may want to think about as you decide on your investing strategy. Some traders make it a strategy to profit from playing the gap when such a situation occurs. 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 time span. Customers seeking educational material on gap trading should look for YouTube content that provides clear explanations and practical examples.

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