Gaps are price jumps or drops that occur when the market opens or closes, leaving a blank space on the chart. They can indicate strong momentum, trend reversal, or market inefficiency. In this article, you will learn what are the most effective TA strategies for identifying and trading gaps.
There are four main types of gaps: common, breakaway, runaway, and exhaustion. Common gaps are random and have no significant meaning. Breakaway gaps occur at the start or end of a trend, signaling a change in direction. Runaway gaps happen during a trend, showing a continuation of momentum. Exhaustion gaps occur near the end of a trend, indicating a final push before a reversal.
Big gap ups and gap downs are always easier to take a trade quickly. The law that works like a charm is, mean reversion. Example: Let's say an index is 20000, if there's a big gap up of 200 points (1%), then for it further going up on that day is difficult. At least initially it needs to take a dip or go sideways in order to respect the mean reversion. Hence, in such cases, call shorts give great results for an intraday trade A similar thing works for a big gap down but one needs to be extra careful to see if that big gap down is due to some major news affecting the market. Else, wait for a 5 or 15 mins reversal candle and then short puts Note, all positions are always to be hedged for safety. Have a stop loss based on your risk appetite
Big gap ups and gap downs are always easier to take a trade quickly. The law that works like a charm is, mean reversion. Example: Let's say an index is 20000, if there's a big gap up of 200 points (1%), then for it further going up on that day is difficult. At least initially it needs to take a dip or go sideways in order to respect the mean reversion. Hence, in such cases, call shorts give great results for an intraday trade A similar thing works for a big gap down but one needs to be extra careful to see if that big gap down is due to some major news affecting the market. Else, wait for a 5 or 15 mins reversal candle and then short puts Note, all positions are always to be hedged for safety. Have a stop loss based on your risk appetite
The difference in each gap is in perspective as stated and however, technical analysts will take advantage of any of them with a proven and working strategy that enhance higher profitability. Vacuum block trading strategy is helpful in this conversation.
Common Gaps:These gaps are a bit like random surprises in a game. They don't have a special meaning; they just happen without much explanation. Breakaway Gaps:Think of breakaway gaps as the start or end of an exciting adventure. They show us that things are about to change in the stock market, like when a story takes a new turn. Runaway Gaps:Imagine runaway gaps as a part of an ongoing adventure. It's like a character in a story who just can't stop – these gaps happen during a trend and tell us that the excitement is going to keep going. Exhaustion gaps are like the grand finale in a story. They appear near the end of an adventure, telling us that there's one last big push before everything turns around.
There are four main types of gaps in technical analysis: Common gaps: These gaps occur frequently and can be found throughout a trading range. They are usually small and do not have a significant impact on the overall trend. Breakaway gaps: These gaps occur at the end of a price pattern and signal the beginning of a new trend. Runaway gaps: These gaps occur along a trend line and are called a runaway gap or a measuring gap. Exhaustion gaps: These gaps occur at the end of a trend and signal a final attempt to hit new highs or lows.
To identify gaps, you need to use a candlestick or a bar chart that shows the open, high, low, and close prices of each period. A gap is formed when the open price of a period is higher than the high price of the previous period (upward gap) or lower than the low price of the previous period (downward gap). You can also use indicators such as volume, moving averages, or trend lines to confirm the significance and direction of the gap.
From the different visual data representation on the chart platform, one of them is candlesticks which shows an opening and closing price for each candlestick. The price of a closing candlesticks supposed to be the opening price of the next candlestick, anytime there is a displacement and "kicker" effect in this, then that is a gap. Next action is to identify what type of gap and take advantage.
Candlestick charts: You can use candlestick charts to identify gaps in the market. A gap is an area on a price chart where the price of an instrument 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. Moving averages: You can use moving averages to identify gaps in forex. A moving average is a technical indicator that smooths out price data by creating a constantly updated average price. When the price of an instrument moves sharply up or down, it can create a gap in the moving average line, which can be used to identify gaps in the market.
Identifying market gaps is a nuanced process that can be approached with sophistication through the integration of cutting-edge technologies. Machine Learning and Artificial Intelligence:By leveraging machine learning algorithms, one can impart the ability to discern intricate patterns and anomalies within historical price data.Employing advanced sentiment analysis tools, which harness the capabilities of natural language processing and machine learning, provides a sophisticated means of gauging market sentiment. Drawing insights from diverse sources such as news and social media, these tools offer additional layers of context to enhance the precision of gap analysis.
There are two main ways to trade gaps: fading and following. Fading means betting against the gap, expecting it to close or fill. This strategy works best for common and exhaustion gaps, which are likely to reverse. Following means going with the gap, expecting it to continue or extend. This strategy works best for breakaway and runaway gaps, which are likely to persist. To trade gaps, you need to set your entry, stop-loss, and take-profit levels based on the size, type, and context of the gap.
I prefer employing options vertical debit spreads as my go-to strategy for trading gaps, especially in the context of swing trades. This approach has demonstrated a notable success rate in generating profits, primarily attributed to the extended time frames associated with swing trades, along with the advantage of avoiding time decay burn commonly observed in options trading. Executing this strategy involves carefully selecting options contracts that align with the anticipated price movements associated with gap trading. The vertical spread creates a range within which the trader expects the price to fluctuate, providing a structured framework for decision-making throughout the swing trade.
Depending on the type of gap to be traded, if it it an exhaustion gap found on the chart and price is above it at a supply zone with showing of rejection, a trader can take a short opportunity into the gap zone before taking profit in the market. Different gaps have different approach.
Fade the Gap: The gap will be filled, and prices will revert to their previous levels. This happens because people's sentiment is not aligned with the price movement, and they will start selling, indicating the price is overvalued. Go with the Gap: The gap will continue in the same direction. This happens because people's sentiment is aligned with the price movement, and they will start accumulating more, indicating the price is undervalued. Gap and Go Strategy: Traders wait for a gap to occur and then enter a position in the direction of the gap. This strategy is often used with stocks that have significant news or earnings announcements.
One more rule for gaps: Gaps to be filled. It means whenever there is a gap on the chart the price action will definitely come back and fill the empty space. Therefore, it is very rational to trade according to this rule.
I don't believe your trading system should have a goal to trade gaps. Let's establish one thing first: gaps occur when there is too much liquidity in an asset class during a certain period. There is no perfect answer to say that there will or won't be more liquidity at any point. If the stock goes up suddenly, creates a gap and then corrects to close that gap, that has very little to do with "closing" the gap and has more to do with liquidity in that trading zone. Technical analysis is not too complicated if you follow three things: Volume/Liquidity, Support, and Resistance. All other jargons are fancy words for people who trade with algo systems.
If you want to trade gaps more effectively, it is important to use higher time frames such as daily or weekly charts to filter out noise and identify reliable gaps. Additionally, it's best to avoid trading gaps during holidays, weekends, or low-liquidity periods as these may be caused by artificial or temporary factors. Before entering or exiting a gap trade, wait for confirmation such as a candlestick pattern, a breakout, or a retest. Lastly, use risk management strategies such as position sizing, leverage, and diversification to protect your capital and reduce your exposure to volatility.
The higher the timeframe the higher the reliability level of such gaps. It is not a must to trade all types of gap at all time frame especially if there is no proper risk management plan a trader is following, owing to the fact that some impromptu events may influence the price direction and can go far away from anticipated zone.
Did you know that only 48% of all gaps get filled on the same trading day? By the time 3rd trading day after the gap, 76% of gaps are filled. Why should you know this? Because there is notion that eventually all gaps get filled. They do not!
Trading Gap-Up Strategy: 1. Confirm the Gap: Ensure the gap is significant by comparing the current opening price to the previous day's closing price. 2. Look for Catalysts: Identify the reasons behind the gap-up. Positive news, earnings reports, or other catalysts can influence a gap-up. 3. Wait for Pullback: It's often prudent to wait for a slight pullback in the stock price after the market opens to enter at a more favorable price. 4. Set Stop-Loss: Establish a stop-loss order to manage risk. If the price moves against your position, the stop-loss helps limit potential losses. 5. Monitor Volume: Confirm the strength of the gap-up by monitoring trading volume. Higher volume can validate the move.
I don't believe your trading system should have a goal to trade gaps. Let's establish one thing first: gaps occur when there is too much liquidity in an asset class during a certain period. There is no perfect answer to say that there will or won't be more liquidity at any point. If the stock goes up suddenly, creates a gap and then corrects to close that gap, that has very little to do with "closing" the gap and has more to do with liquidity in that trading zone. Technical analysis is not too complicated if you follow three things: Volume/Liquidity, Support, and Resistance. All other jargons are fancy words for people who trade with algo systems.
Let's look at some examples of gap trading using the EUR/USD daily chart. In March 2020, there was a downward breakaway gap that marked the start of a downtrend, so you could have followed the gap by selling the pair after it opened and placing your stop-loss above the gap and your take-profit at the next support level. Similarly, in July 2020, there was an upward runaway gap that confirmed the continuation of an uptrend, so you could have followed the gap by buying the pair after it opened and placing your stop-loss below the gap and your take-profit at the next resistance level. Conversely, in November 2020, there was an upward exhaustion gap that signaled the end of an uptrend, so you could have faded the gap by selling the pair after it opened and placing your stop-loss above the gap and your take-profit at the previous support level.
May 6th 2021. GBP/USD on H4 created a gap close to 80pips as new week opening gap (NWOG). Which happened to be an exhaustion gap that was later filled, and turned to new resistance zone with a significant rejection of price after a raid and hence, a massive rally bearish ride.
If you want to learn more about gap trading, you can check out these resources:
- Investopedia: Gap : A comprehensive guide to the definition, types, causes, and implications of gaps.
- Babypips: Trading Gaps 101 : A beginner-friendly tutorial on how to trade gaps in the forex market.
- TradingView: Gap Screener : A tool that helps you find and analyze gaps across different markets and time frames.
There are different sources and reliable ones on the internet via social media pages or accounts of professional traders that give out valuable insight for free to those that are willing to learn. We have enough on Twitter, Youtube, Slack, Discords, Telegram and Instagram. Others are websites of famous and less utilized websites of some forex trading academies.
gaps create untouched price zone. (virgin money zone,CPR and other theory will be quite useful). Virgin Point of Control (VPOC) is a concept derived from market profile analysis, a technique used in technical analysis to evaluate the distribution of price and volume over a specified time period. The VPOC represents the price level at which the highest volume of trading occurred during that period. Traders often use VPOC as a tool to identify potential support and resistance levels. Here's a general guide on how VPOC can be used in a day trading setup:
Tokenist: This website offers a comprehensive guide to gap trading, including the basics of what a gap is, why they occur, and how traders can potentially benefit from using them to inform their stock trades. The guide also covers different types of gaps, real-life examples, and strategies that gap traders employ. Udemy: This online learning platform offers a course on gap trading strategies that covers the basics of gap day trading, including identifying gaps, understanding the psychology behind gaps, different types of gaps, and developing a gap trading plan. FOREX.com: This website offers a guide to using gap trading strategies in forex trading. StockCharts.com etc...
One of the trading scenarios that consistently captures my attention is the daily gap in $VIX. The attractiveness of this opportunity lies in the historical data, which indicates a remarkable 100% fill rate for $VIX gaps. This statistical consistency lends a significant degree of confidence to the potential success of a trade based on exploiting this particular market behavior.