Gap trading strategies: a comprehensive guide

There are several ways traders interpret and approach these market gaps. Want to know more about the types of gaps and which trading strategy could be considered for them? Read on.

Remember, while technical patterns can help identify market setups, past performance is not a reliable indicator of future results.

What is gap trading?

Gap trading is a trading strategy that focuses on price gaps. A gap is an empty space on a price chart. It happens when an asset’s price opens higher or lower than its previous close. This can happen overnight. It can also happen after a weekend. These gaps show a sudden change in supply and demand. Traders try to profit from these movements. A gap trading strategy tries to predict what the price will do after the gap.

Now, gaps can occur for many reasons. They are often caused by major news breaks. An unexpected earnings report can cause a gap. An announcement about a company launching a new product can cause a gap. After-hours trading can also cause a gap. Strong buying or selling can lead to such gaps, with the price opening differently the next day. This creates a gap on the chart.

However, it is important to know the difference between a gap and a gap fill. A gap is the initial jump in price, while a gap fill is when the price moves back to close that gap.

Open a demo account to see how gaps can form on price charts without investing any real money.

Types of gaps in trading

Not all gaps are the same. A successful gap trading strategy requires understanding the different types of gaps in trading.

Common gap

A common gap is the least important type. It is usually small and happens often. It typically occurs in sideways or non-trending markets. These gaps are almost always filled quickly. They do not signal a major change in price trend.

Breakaway gap

A breakaway gap is very significant. It happens when the price breaks out of a trading range. It signals the start of a new, strong trend. This type of gap usually occurs with high volume. It shows a major shift in investor sentiment. These gaps often do not get filled for a long time. They show powerful momentum.

Runaway gap

A runaway gap happens in the middle of an established trend. It is also called a continuation gap. This type of gap confirms that the current trend is strong. It shows that more traders are joining the trend. It usually happens on medium volume. Like the breakaway gap, it signals strong momentum. These gaps typically do not get filled quickly.

Exhaustion gap

An exhaustion gap signals the end of a trend. It is a reversal pattern. It appears near the end of a long move. The price makes a final, large gap in the trend’s direction. This is often followed by very high volume. The high volume shows a final rush of buying or selling. The price then quickly reverses direction. This gap is usually filled immediately as the trend reverses.

Past performance isn’t a reliable indicator of future results.

How different gaps behave in various market conditions

The behaviour of a gap depends on the market. During a strong trend, breakaway and runaway gaps are powerful signals. They confirm the direction of the trend and tend to stay unfilled for a long time.

In a sideways market, common gaps are frequent. They get filled very fast. After a long-lasting trend, an exhaustion gap signals caution among investors. It suggests that the trend is about to end. It leads to a quick reversal and gap fill.

Understanding gap fill

‘Filling the gap’ means the price moves back to the level of the previous close. The gap is then ‘closed’ on the chart. A gap fill strategy is a popular approach. Traders speculate that the price will move back to the previous day’s close.

Why do gaps often get filled? There are a few reasons for this.

• Psychological reasons: traders often see gaps as unnatural. They believe prices should trade continuously. The urge to ‘fill the gap’ is a common belief.
• Technical reasons: gaps can act as support or resistance levels. The price might re-test the gap area, acting as a magnet.
• Mean reversion: asset prices tend to come back to the mean over time. A large gap is a large deviation from the average price. So, the price will correct to a more normal level.

However, a gap might not always get filled. This is especially true for breakaway gaps. The momentum is too strong and/or the new trend is powerful. The strong buying or selling pressure prevents the gap from filling.

Best gap trading strategies

There are many ways to trade gaps. Each strategy is different. Learn about the different trading strategies to choose one that best suits your trading psyche and goals.

Gap and go strategy

This strategy targets strong, immediate momentum. It works best with breakaway gaps. Here, traders wait for the price to open much higher or lower than the previous close. This must be accompanied by high volume. The goal is to ride the initial continuation.

Entry: open a long or short position (based on the direction of the gap) immediately after the market opens. This is a breakout entry.

Stop-loss: place the stop-loss just inside the gap area. Use the low (for a gap up) or high (for a gap down) of the initial gap candle.

Take-profit: target a pre-defined risk-to-reward ratio (such as 1:2 or 1:3). You can also exit the position when momentum indicators weaken.

Gap fill strategy

This strategy is based on the expectation that the gap is temporary and will get filled. It is a mean reversion approach. It works best for common gaps or failed momentum moves. The price is expected to return to the previous day’s close.

Entry: wait for the price to show weakness (or strength) near the open. For a gap up, open a short position when the price fails to hold the open.

Stop-loss: place the stop-loss above the high (for a short trade) of the gap’s range.

Take-profit: the primary target is the gap fill level. This is the previous day’s closing price.

Breakaway gap strategy

This strategy is similar to the gap and go strategy, but you need to be more patient. It focuses on the power of significant news to move asset prices. The breakaway gap is expected to signal a new trend.

Entry: wait for the initial volatility to settle. Enter the trade on a clear continuation pattern. This is often a breakout from a small consolidation after the gap.

Stop-loss: place the stop-loss below the entire gap area. The gap must not be filled.

Take-profit: use the initial gap range to project a target. This gap often marks a long-term move.

Exhaustion gap strategy

This gap trading strategy is a counter-trend one. It targets the end of an established trend. The exhaustion gap shows a final, desperate push for the trend to continue. However, this final push quickly fades and the trend reverses.

Entry: take a position opposite to the gap direction. For a gap up, open a short position. Enter when the price fails to make new highs after the gap.

Stop-loss: place the stop-loss just beyond the high or low of the exhaustion gap candle.

Take-profit: target the start of the final push. The price is likely to fill the gap entirely.

End-of-day gap trading

This strategy anticipates a gap the next day. It uses strong momentum late in the session to predict such a gap. Traders speculate that the buying or selling pressure will continue overnight, creating a gap.

Entry: buy or sell the asset near the market close level. You are positioning for the overnight move.

Stop-loss: place a wider stop-loss based on the expected overnight volatility. A percentage-based stop-loss is common.

Take-profit: the goal is to sell (or buy back) when the market opens the next day. The profit is the size of the overnight gap. This is a high-risk, high-reward strategy.

Past performance isn’t a reliable indicator of future results.

How to identify gaps before the market opens

Identifying gaps early is crucial for any gap trading strategy. For this, you need the right tools and information.

Using scanners and screeners

You can use a stock scanner or screener to check multiple stocks quickly. These tools allow you to set specific criteria. For example, you can ask for stocks that gapped up by over 5%. The scanner finds these stocks before the market opens.

Pre-market trading volume

High pre-market trading volume suggests strong interest. A large gap with low volume is often unreliable. So, use volume indicators to check for high volume to confirm that the gap is serious.

Earnings, calendars and catalysts

Check the economic and corporate calendars. Economic data releases and company earnings reports are major catalysts. Unexpected news can also cause a gap. Look for breaking news or company announcements. A gap can occur in response to the news.

Filtering by float size, volatility, and previous day’s range

Filter the results to find the best trades. Float size is the number of shares available to trade. Low-float stocks can move more dramatically. Also, filter by volatility, since high-volatility stocks tend to have bigger gaps. Check the previous day’s range. A gap that breaks far out of that range is more significant.

Tools and indicators for gap traders

To increase confidence in your gap trading strategy, use other technical indicators and tools to confirm signals.

Volume analysis

Volume is the most important tool. High volume shows strong institutional interest. A breakaway gap needs very high volume to be reliable. A common gap has low volume. Low volume on a big gap can mean a quick failure. Volume confirms the gap’s type and strength.

VWAP

Volume-weighted average price (VWAP) shows the average price traded throughout the day. This average is weighted by volume. Traders use VWAP as a key reference point. A stock that gaps up and stays above VWAP shows strong buying pressure. A stock that gaps down and struggles to get above VWAP shows strong selling. VWAP acts as a temporary support or resistance level.

Moving averages

Moving averages can show the general trend. You can use them to see the bigger picture. A gap that moves the price above a long-term moving average is significant. For example, a gap above the 200-day moving average suggests a major shift. This adds confidence to a long trade. Moving averages help confirm if the gap is trading with or against the main trend.

Candlestick confirmation

Look at the first few candlesticks after the open. A strong bullish candle after a gap up confirms momentum. A bearish candle after a gap up suggests immediate selling pressure. This can signal a failed gap or a possible gap fill strategy opportunity. Candlestick patterns (like a bullish engulfing pattern) immediately after the open provide confirmation.

Using pre-market charts effectively

The pre-market chart shows the price action before the official market open. It helps you see where the high and low of the pre-market range are. These pre-market highs and lows often become key support and resistance levels. Watching pre-market volume helps you gauge interest. The pre-market chart defines the true extent of the gap before the main market opens.

Risk management in gap trading

Managing risk is critical because gap trading is volatile. Gaps cause sudden price movements. So, make sure you protect your capital with appropriate risk management measures.

Setting proper stop-loss

A stop-loss order is essential for every gap trade. It limits your potential loss. The location depends on your strategy.

For a momentum trade (gap and go)

If you go long (expecting the gap up to continue), place your stop-loss just below the low of the gap. If the price drops below this point, the momentum has failed, and the reversal is likely. If you open a short position (anticipating that the gap down will continue), place your stop-loss just above the high of the gap.

For a gap fill trade (mean reversion)

For short positions (expecting the gap up to fill), place your stop-loss slightly above the previous day’s high or the highest point of the gap. If the price moves past this point, the gap is likely to be a breakaway gap and won’t fill quickly.

Percentage risk

You can also use a fixed dollar or percentage risk rule to manage risk. Limit your loss on any single trade to a small percentage of your total trading capital (such as 1%-2%). This ensures no single gap trade can wipe out your account.

Managing false breakouts and fake fills

False breakouts and fake fills are common risks in a gap trading strategy. This is when the price briefly moves in the expected direction, but then quickly reverses.

To avoid falling for false breakouts or fills, wait for confirmation. Don’t enter a trade immediately at the open. Wait for the first candlestick to close. This confirms the initial direction. If a stock gaps up but the first 5-minute candle closes red, the momentum may be failing.

You can also use time filters. For a gap-and-go trade, wait until the price clears the pre-market high or low for several minutes. A quick spike followed by a return to the middle of the gap is often a fake-out.

Finally, avoid the immediate open. The first minute of trading is often the most volatile. Smart traders wait 5 to 15 minutes before entering to let the chaos subside.

Sizing your position based on gap type and volatility

Position sizing is a popular way to manage risk. For periods of high volatility, smaller position sizes are considered safer. A smaller size means the asset can move more before hitting your stop-loss, keeping your dollar risk constant.

Position size can also be based on the gap type. Treat breakaway gaps as higher-conviction trades but still size conservatively due to volatility. Common gaps can be treated as lower-conviction trades, often requiring a larger stop-loss and a smaller position size to manage dollar risk.

Always size your trade so that if your stop-loss is hit, you only lose your predefined maximum dollar risk (such as 1% of your account capital).

Avoiding FOMO in gap and go setups

Fear of missing out (FOMO) can lead to impulsive or irrational trading decisions. Gap and go setups can move extremely fast, triggering FOMO in many traders. To avoid this:

• Don't chase the price: if the stock opens and immediately shoots up 5% in 30 seconds, the entry window is closed. Chasing the price means you enter with a terrible risk-to-reward ratio. Your stop-loss will be very far away.
• Stick to your entry plan: only enter at your pre-determined price level. If you miss the trade, let it go. There will always be another gap trading opportunity.
• Focus on the next setup: if you miss the gap and go, look for a new setup. The price might consolidate and offer a second entry. This entry is often safer than the initial volatile move.

Gap trading in different markets

Gap trading strategies can be used across different markets. Here’s a look at popular ways to trade gaps.

Stocks

Stock markets tend to be closed overnight. Trading happens during a limited period. This causes many gaps. Pre-market and after-hours trading create these gaps. News released after hours also affects stock prices. The price then gaps at the next day’s open. Earnings gaps are also very common. A surprise earnings announcement can cause a huge gap. For example, if a company reports better-than-expected earnings after the close, its stock could open even 10% higher the next day.

Forex

The forex market is active 24/5. So, forex gap trading focuses on the weekend gap. News released on Saturday or Sunday affects currency prices. The market then opens on Monday with a gap. This often happens in major currency pairs. For example, the EUR/USD pair might close at 1.1000 on Friday. Over the weekend, there’s a major European political news break. The EUR/USD could then open at 1.0950 on Monday. This creates a gap.

Liquidity gaps can also happen in the forex market, although these are rare. They happen during major economic announcements. Very few people trade them.

Crypto

The crypto market trades 24 hours a day, 7 days a week. It never officially closes. Due to this, price gaps are less frequent in this market. However, gaps still occur. They are usually caused by a sudden, major news event. This could be a regulatory announcement or a major security breach. Most crypto gaps are news-based. For example, a major government announces a ban on crypto trading. This could lead to the price of bitcoin dropping suddenly. If trading volume is low during that news, a visible gap can form on the hourly chart. This is a quick and severe price jump.

Pros and cons of gap trading

One of the major advantages of a gap trading strategy is that gaps can be powerful signals. They show strong momentum. Plus, gaps can happen often, leading to multiple trading opportunities. Gap trading can also be versatile. You can use it for intraday trading as well as swing trading.

However, gaps tend to be very volatile. Prices can move very fast, which can lead to big losses. In addition, gaps can be misleading. They can be false signals. Without confirmation, you can lose money. Also, gaps are often caused by news. So, you not only need to stay updated on the latest news breaks but also understand them.

Common mistakes in gap trading

The best way to avoid making mistakes is to learn about the most common ones.

• Trading without volume confirmation: never trade a gap without checking the volume. High volume is crucial. Low volume can mean a quick reversal.
• Ignoring market context: always look at the overall trend. A breakaway gap is powerful in a bull market, while an exhaustion gap is powerful at the end of a long trend.
• Over-leveraging: don’t use too much leverage. Gaps are volatile, and you could get a margin call very fast.
• Trading low-float stocks: low-float stocks are very volatile. They can move without warning. They are best avoided unless you have a clear plan.

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