Mind the Gap: How to Trade Price Gaps
The Power and Beauty of Price Gaps
Price gaps represent a clear imbalance in supply and demand, making them one of the purest representations of momentum in financial markets. These gaps occur when there is a significant disparity between the closing price of one period and the opening price of the next, indicating a sudden surge in buying or selling pressure.
How to Trade Price Gaps: 3 Different Strategies
1. Gap & Go:
Description: This strategy involves trading in the direction of the gap, anticipating that the momentum will continue.
Execution: Enter trades as soon as the market opens, aiming to capture the initial momentum surge.
Timeframe: Typically applied on shorter timeframes, such as intraday charts.
Risk Management: The gap can be used for stop less shelter, hence stops can be placed above (below) the gap.
Example: Tesla (TSLA) 5min Candle Chart
In this example, Tesla gaps lower at the open – breaking below a key level of support and signalling the breakdown of a sideways range. The gap follows through to the downside during the remainder of the trading session.
(Past performance is not a reliable indicator of future results)
2. Gap Fill:
Description: In contrast to the Gap and Go strategy, this approach involves fading the initial price movement and trading in the opposite direction of the gap.
Execution: Wait for price to retrace back to pre-gap levels before entering trades, anticipating that the gap will eventually be filled.
Timeframe: Can be applied on various timeframes, depending on the magnitude of the gap and market conditions.
Risk Management: Implement stop-loss orders to manage risk, as price may continue to move against the trade.
Example: Barclays (BARC) Hourly Candle Chart
Barclays gap above key resistance on the hourly candle chart. The gap is filled and broken resistance turns to support prior to the uptrend resuming.
(Past performance is not a reliable indicator of future results)
3. First Pullback:
Description: This strategy combines elements of both Gap and Go and Gap Fill, focusing on entering trades after the initial momentum surge but waiting for a pullback or consolidation before entry.
Execution: Wait for the first pullback or consolidation after the gap before entering trades in the direction of the prevailing momentum.
Timeframe: Suitable for both shorter and longer timeframes, depending on the magnitude of the gap and market dynamics.
Risk Management: Utilize stop-loss orders to protect against adverse price movements and adjust position sizing based on volatility.
Example: Arm Holdings (ARM) Hourly Candle Chart
Arm’s share price puts in a large price gap which breaks decisively above a key level of resistance on the hourly candle chart. Given the size of the gap, optimal entry requires waiting for the market pullback.
(Past performance is not a reliable indicator of future results)
Additional Factors to Consider
Catalyst Behind the Gap:
• Look for stock-specific news events that recalibrate market expectations, such as earnings surprises or changes in outlook.
• Mechanical events like dividends or corporate actions are less likely to sustain momentum.
Size of the Gap:
• Larger gaps indicate stronger momentum but also carry a higher risk of mean reversion.
• Assess the magnitude of the gap relative to historical price action and volatility.
Levels Broken:
• Consider the significance of key support and resistance levels broken by the gap, as they may influence the strength and direction of the price movement.
Prevailing Trend:
• Analyse the prevailing trend before the gap and assess whether the gap aligns with the overall market direction.
By incorporating these factors into your analysis and selecting the most suitable strategy based on market conditions, you can effectively trade price gaps and capitalize on momentum opportunities in the financial markets. Remember to exercise proper risk management and adapt your approach as market conditions evolve.