A gap is when a stock price sharply rises or falls but no trading activity has taken place in that time. This gives the trader an opportunity to take advantage of the imminent change in demand for that stock.
What is Gapping?
Have you ever seen a break between the closing and opening price of a stock, without any trading between the prices? If yes, you probably didn’t know that this market phenomenon has its name – it’s called gapping. In this article, we’ll cover why a stock price gaps, what types of gaps exist and what does “gap up” mean in stock trading.
Why Does the Stock Market Gap?
Gaps occur when the opening price of a stock differs from its closing price. While we’ll focus on stock gaps, they can also appear in any other financial market. A gap usually occurs in times of low market liquidity, when there are not enough buyers and sellers to prevent sudden drops and spikes in the price.
This can even happen in markets which usually have a high volume of trading, such as the Forex market. In the stock market, you’ll usually find gaps after a trading day closes and the market opens the next day again. Important events such as earnings releases and company-related news can impact the market sentiment after the stock closes, leading to gaps in the price of a stock when the stock opens.
Types of Gaps
Depending on the current market condition, not all gaps are the same. Here’s a list of the most common types of gaps:
Common gap – As their name suggests, these are the most common gaps in the market. They frequently occur in the stock market when a new trading day starts, or in the Forex market after the weekend trading pause. They can also occur in the middle of the trading day in times of strong buying or selling pressure.
Breakaway gap – A breakaway gap usually occurs at top of uptrends and at the bottom of downtrends, signalling a potential trend reversal. They can also form during breakouts of major chart patterns, and can be intensified by a high trading volume.
Continuation gap – Continuation gaps occur in the middle of strong uptrends or downtrends, in the direction of the underlying trend. They signal that a strong buying pressure exists in uptrends, or that a strong selling pressure exists in downtrends.
Exhaustion gap – Exhaustion gaps form during strong uptrends or downtrends, but in the opposite direction of the underlying trend. They signal that the trend is starting to lose momentum, and that a potential reversal is ahead.
Filled gap – After a gap forms, markets often fill the gap between the closing and opening price. This is especially true with common gaps, and can be used to build a trading system around them.
Playing the Gap
Depending on the type of gaps formed, traders can build a trading strategy and try to profit on them. A gap up or gap down can create profitable trading opportunities if you know how to trade them correctly. As a rule of thumb, here are some points traders need to consider when trading gap:
- Common gaps should be traded in the opposite direction, as the market often fills the gap shortly after they occur.
- Continuation gaps signal a healthy and strong underlying trend, and traders can look to enter in the direction of the trend after a continuation gap occurs.
- Exhaustion gaps have a proven track-record of signalling trend reversals, and traders should look to enter in the opposite direction of the trend after they spot an exhaustion gap.
Still, make sure to use other tools to confirm a trade based on gaps. Reversal and continuation chart patterns, combined with support/resistance levels and gaps can be used to develop a well-round trading strategy to buy or sell stocks.