What is gap trading?
Considering the above information, what does ‘trading the gap’ mean? In simple terms, traders identify gaps between opening and closing prices on a trading chart where there has been volatile action, and can use this to devise an appropriate trading strategy. They will then need to calculate potential entry and exit points for their trades. Traders often use event-based strategies when there is a market gap, as they can predict but not guarantee what will happen next.
There are also different classifications of gaps, as they do not all represent the same price pattern or trend on a price chart. These can be split into the following:
Breakaway gaps: these happen at the end of a pattern and signal the beginning of a new trend.
Common gaps: these represent an area where the price has gapped but nothing else.
Continuation gaps: these are caused by a rush in supply and demand that occur in the middle of a price pattern.
Exhaustion gaps: these happen near the end of a pattern and signal a last attempt to hit price highs or lows.
Stock gap analysis
There are two levels of gapping within the stock market: partial and full. Partial gapping is when a share’s opening price is higher or lower than the previous day’s close but within the typical range, whereas full gapping is when a share’s opening price is outside of the range. A full gap shows that the market was particularly volatile overnight and the market sentiment for this share has changed.
The imbalance between supply and demand of a particular stock pushes its price outside of support and resistance levels overnight, which leads to gaps in a chart. Sometimes, this gap is filled back to its original level. This can indicate that the price rally was misunderstood, too optimistic, or investors have had a more thorough look at the earnings report and spotted weaknesses. This can lead them to sell their positions, bringing the share’s value back to its original level.
