Author: Doumkou Stefani
Publication date: 01.10.2024
For those active in the trading world, it's almost certain they have encountered phenomena known as "gaps" in price movements on charts. This article aims to explain these gaps and provide answers to basic questions that may arise for inexperienced traders, newcomers, or anyone interested in understanding how these gaps influence price trends and market behavior.
What Are Price Gaps and Trading Gaps?
A price gap in a chart happens when the price of a stock or asset jumps from one level to another, without any trading in between. This leaves a blank space on the chart, called ‘’gap’’.
Gap trading is a strategy where traders look to profit from these gaps. They try to predict whether the price will continue in the direction of the gap or reverse and fill the gap. Depending on the type of gap (whether it's caused by news, earnings, etc.), traders either follow the trend or bet on the price returning to the original level.
Why Do Trading Gaps Occur?
Gaps occur as a normal part of market behaviour. They happen for various reasons, often due to sudden changes in the perceived value of a financial instrument. These shifts are typically triggered by unexpected news, technical breakouts, algorithmic trading, or low liquidity conditions, causing prices to move sharply with little or no trading in between.
Different Types of Gaps and How to Identify Them?
1. Breakaway Gap
Occurs at the beginning of a new trend, usually breaking out of a consolidation or a key support/resistance level. The price moves sharply up or down, breaking away from a period of consolidation (a tight range where the price moves back and forth without a clear trend). Usually, it is accompanied by strong volume, indicating a significant move in the gap's direction. Breakaway Gaps usually occurs due to major news or events, such as earnings reports, new product launches, or political events. These gaps are often followed by a strong trend.
2. Exhaustion Gap
An Exhaustion Gap appears near the end of a trend, signalling that the trend is running out of steam and a reversal is likely. Occurs after a long price movement. Shows declining volume and is often followed by a price reversal. This kind of gap happens because traders who were pushing the price higher (or lower) may be getting tired, and new buyers (or sellers) are not coming in to support the move. After this gap, the price typically moves in the opposite direction.
3. Common (Area) Gap
A common Gap or an Area Gap appears without any major significance, often in a sideways (not trending up or down) or range-bound market. It often happens because of normal buying and selling activity or low trading volumes. Common gaps are generally small and tend to be filled quickly, meaning the price moves back to the level where the gap started. No major news or trend present when the gap appears.
4. Continuation (Runaway) Gap
A Runaway or Continuation Gap happens in the middle of a strong and already existing trend. It suggests that the current trend (upward or downward) is still strong and is likely to continue. These gaps usually occurs due to an increase in momentum, as more traders join the move, fuelling the existing trend. Unlike a breakaway gap, a runaway gap shows that the trend is getting even stronger. Volume is moderate, and the price usually continues moving in the gap’s direction.
Are Gaps Win-Win for Traders and Assets?
Gaps in trading offer both opportunities and risks. They aren’t always "win-win," but can lead to profits for traders who interpret market signals well. For stocks and cryptos, gaps are neutral events, reflecting market behavior without directly benefiting or harming the asset. Success depends on how traders manage these volatile price movements.
Conclusion
Gap trading as a trading style balances between profit potential and the risks associated with market volatility and unpredictability. The reliability of a gap depends on its type. To succeed, traders need to consider additional risk factors, such as market trends and conditions, which can help improve decision-making and reduce risk. By carefully managing these elements, traders can increase their chances of success with gap trades.
Final Tips
For those interested in trading gaps here are some final tips:
! Identify the Gap Type: Know whether it's a common, breakaway, runaway, or exhaustion gap for better decision-making.
! Understand the Gap: Not all gaps are trade-worthy. Make sure to understand why the gap happened (earnings report, news, etc.)
! Check Volume: High volume confirms gap strength; low volume can signal false moves or reversals.
! Look for Gap Fills: Many gaps, especially common ones, often fill. Trade accordingly if retracement is expected.
! Use Stop Losses: Set stops just outside the gap to protect against volatility.
! Trade with the Trend: Gaps in the trend's direction are stronger. Avoid trading against major trends unless it's an exhaustion gap.
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