Breakaway price gaps often indicate that a given asset is in the throes of a sustained breakout from a trading range.
Such gaps can be either a bullish or bearish signal, pointing to a change in investor sentiment, especially following significant news flow.
Common price gaps tend to be relatively small in comparison to breakaway gaps. For instance, a stock may open at only a slightly higher level than it previously closed at.
In the case of a breakaway price gap, we should see the next price on the candlestick chart at a significantly different level.
This gap is less likely to correct itself in the following trading sessions as with a common price gap, but rather could be the beginning of a new bullish or bearish trend.
With a true breakaway price gap, we should observe some increase in trading volume following a period over which the asset has been stuck in a trading range.
At the top of the area of the recent trading range, the peak price points of this phase indicate the price level around which the asset has come under selling pressure, and so equate to a line of resistance.
At the bottom, the trough price points denote a price level where buyers have come into the market to take advantage of more attractive prices, and so is a line of support.
As the price has been hemmed in this trading range for some time, it will take a significant change in sentiment to push it over either the upper or lower line of the range.
When a breakaway price gap occurs, and it is accompanied by higher trading volume, we can take a position in line with the same direction of the gap.
For instance, in the case of a breakaway gap up in the price, we could implement a buy order. In the case of a breakaway gap to the downside, we would initiate a short position in the asset.
Trading the breakaway gap
As an example, suppose Tesla shares open Monday’s trading session at a sharply lower price than where they ended on Friday. The catalyst was a report in the Wall Street journal over the weekend claiming that Tesla is being forced to delay deliveries of its Model 3 electric car yet again due to production glitches.
Having closed at $266 on Friday, the share price opens Monday’s session at $252 amid higher trading volume. It comes after the share price has traded in a range of $275 to $255.
In order to capitalise on what appears to be a meaningful breakout to the downside, we initiate a sell order at $251. By the end of the day, the Tesla shares are trading at $240, but we decide to hold our position as we believe the shares will fall further.
We close out the trade the following day when the shares are at $235, extremely pleased with the result.
A reasonable way to calculate the profit target on a breakaway price gap trade is to apply the height of the prior trading range to the breakout level. So, in our example, our profit target could be: $20 ($275 − $255) − $255 = $235.
Of course, we will want to implement a stop-loss order to guard against losing money due to a false breakout.
Suppose, for instance, that during Monday’s trading session Tesla announced that indeed there has been another delay on the Model 3, but that this will only be a few weeks as the problems are now resolved.
The share price could then move back through the breakout level to finish the day around Friday’s close, at $266. To mitigate against this sort of event we could implement a stop-loss order on the trade just above the $255 breakout level, say at $256.