The most common definition of a gap is having a price difference between the closing price on one day, and the opening of the next day.
The key is the market has to have a time when the market physically opens and when markets close, as in the stock and futures market
Forex has gaps that can occur between the Friday close and Sunday open. In currency trading, we have another type of gap that we can trade as they are more common and we will look at that later.
It is possible to trade gap setups and the key is to know the different types of gaps you will face in trading.
4 Types Of Gaps In The Market
There are 4 types of gaps in trading but you do not treat all of them the same. Some of the gaps you will see will be “gap filled” or “filling the gap” which means price will reverse to the point of origin.
Other gaps don’t get filled and you must know the different. Attempting to fade certain gaps can be a costly mistake.
Common Gaps – Filled Gap
The name says it all.
This type of gap usually occurs in trading ranges as well as in a trending move. These gaps are filled and given the name, it’s difficult to forecast future price movement from them.
Price will form a consolidation, price will spike out of it, and return relatively quickly filling in the gap. This can take a few different forms but the concept is the same. Trading gaps like this is a common practice.
From an analysis standpoint of the market, it does not tell you much in the way of the next probable move.
Exhaustion Gaps – Filled Gap
This is the second type of gap where you can look to trade the gap fill. These are found at turning points at the top and bottom of a trending market. The exhaustion gap has 2 variations that traders will term “exhaustion”
The first one is a gap into a previous support or resistance level.
The key is you want to see weeks of a directional market as we see here. You can see the gap is filled relatively quickly. Your gap trading strategy would have a way to trigger yourself into a position in the opposite direction of the thrust in price.
Some traders will use an uptick in volume, especially after the gap and as price reverses, to confirm the reversal.
In the second variation, price turns at the resistance level and gaps down in price. You can also get both variations on the same chart.
Being involved in the first variation gets you in the trade before the second variation gap resulting in quick gains on your position.
If you use gaps for analytic purposes, the exhaustion gap can point to corrections or full trend reversals.
Breakaway Gap – Not Filled
The defining feature is having a support or resistance area that has been tested multiple times. The breakaway gap is a confirmation of a new trend direction which usually starts out of a chart pattern such as a channel or wedge. Even breaks of trend lines can have breakaway gaps and you would want to trade the trend line break a little differently than waiting for a pullback.
This will not have a gap fill.
Attempting to fade the break during what appears to be a fill attempt, would have you hurting as price bases and then gaps again.
While breakaway gaps can confirm a new trend after a reversal, this particular gap was a continuation of the trend after a consolidation period.
Runaway Gap – Not Filled
This gap can occur at the beginning of a new trend or in the middle of the current trend. You could even see the runaway gap after the breakaway gap when the new trend is strong.
Why would this gap occur?
Remember that some gaps fill and in that case, you’d wait for the retracement to get on board the trend.
When there is no fill of the gap, there is no retracement in price. Traders anxious to get on board may wait for any pause in the price action and when they get it, traders pile in driving the price.
This is a one hour intra-day chart and if you go up in time frames, you can have this pause as one bar. You can see price broke to the downside with a no gap fill. The first time to get on the move was at the first pause. Traders who were waiting to get on the train generally cause the gap to take place.
From an analytic perspective, you are looking at a market that is in a strong directional move and attempting to fade price, can be costly.
Gaps in Liquidity
There is another type of gap that you should be familiar with and it is not a physical gap on your chart. Traders will see these gaps as long candlesticks or bars on the chart.
You can see the size of this bar compared to the others on this chart. These are useful in the same locations as the physical gaps you see on the charts.
Trading these types of gaps is no different than the ones we’ve already covered.
Gap Trading Strategies
We don’t need list out a ton of trading strategies for gaps because in the bigger picture, we are looking at two variations:
- Two gaps generally get filled
- Two gaps happen and don’t look back
We can consider these gaps to be mean reverting which means we can look to fade a certain level or reversal chart pattern.
Once you recognize a gap that fills, considering using a stop order to enter, in this example, when the doji breaks to the downside.
Trader will often use a multiple time frame approach by:
- Noting the common gap occur
- Dialing down to a lower time frame
- Finding a reversal pattern or trend line break
This is the four hour chart of the same area. We have a few choices for entry including a double top chart pattern.
Why would I not short the range at high of momentum bar (gap bar)? That is generally a bullish setup although it doesn’t always mean a strong continuation.
Unfilled Gap Entries
It is far too easy to jump into trades when we see heavy price action but that is a mistake. We need to find a way to enter that has an edge, no matter how slight it may be.
There are many ways to enter these types of trades. In this example, you can trade the trend line break, the rejection of support, or an indicator type of trading trigger.
The key is to look for some type of pause in the market that will allow us to jump into the trade. Ranges and pullbacks are the simple choice.
Trading Gaps Conclusion
The toughest part of trading gaps successfully is distinguishing which ones have a risk of getting filled or to keep running.
The type of gap you trade is as important as how you will enter it. The basic concept is gaps that fill, think mean reversion which requires some type of reversal signal.
For gaps that do not fill, you need an entry that uses some type of consolidation. Whichever you use, the trade entry is only part of the trade. Risk management and stop loss is vital especially if you get it wrong—which you certainly will at times.