What is Gap Trading?
Gap trading is an approach to buying and shorting stocks that is simple as well as disciplined. You search for stocks that have a price gap from the previous close, then you watch the first hour of trading to establish the trading range. If the shares rise above that range, this is a signal for you to buy, if it falls below that’s a signal for short.
A gap is defined as a change in price levels between the close and open of two consecutive days. In fact, many technical analysis manuals define four types of gap patterns:
However, it’s important to remember that these labels are applied after the chart pattern is identified. This means that the difference between any one kind of gap from another is only evident after the stock continues up or down in some way. These classifications are useful to traders seeking a longer-term understanding of how a stock or sector performs and reacts; however, they offer little guidance for trading.
Many brokers develop their own set of terms when describing gaps so that you may come across, for example, a full gap up, a full gap down, a partial gap up, or a partial gap down.
The Characteristics of Gaps: The Breakaway Gap
You will soon find that gaps are a common occurrence in the markets, as there is always at least one stock, if not more, that has gapped up or down when the market opens. This occurs because when an event happens somewhere between the market close the previous day and the opening of the market the next day, there will be gaps. Even as the markets eventually move step by step towards a 24-hour format, there will still be gaps. Across the globe, you can be sure that there will be some event happening over the weekends. Additionally, sometimes a group of investors get excited and make a big deal out of something, even when the reason is not always apparent. As gaps are here to stay, the best response is to take them in stride and learn how to profit from them.
Let’s look at the breakaway gap in a bit more detail. Breakaway gaps are a little more challenging to manage than other types because when the gap occurs It can be trickier to estimate which way it’s going. For instance, when a stock has been in a consolidation stage, it often breaks out with an opening gap rather than making a standard market session move. Usually, the gap will open in the same direction as before the consolidation stage, however, this is by no means guaranteed.
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Runaway Gaps and Exhaustion Gaps
Runaway gaps appear when a stock has been trending for some time. You can spot them as, instead of moving up as usual during market hours, they open with a gap that continues the dominant trend.
This demonstrates there is more interest in the stock. It may be that some positive news has boosted investors’ incentive to own it. Runaway gaps are sometimes also called measuring gaps because they are often used as a central point of measurement between the beginning of the trend to the gap, and then from the other side of the gap to predict the next likely level it would reach.
Exhaustion gaps occur when the market has been trending for an extended period, generally after a bull market, when prices are rising, or a bear market, when prices are falling that has lasted for a few years. Exhaustion gaps trigger a slowing down of the trend or a period of consolidation. Gap traders need to be careful not to confuse an exhaustion gap with a breakaway gap as they can have a similar impact at first. The trick is to look at where they are appearing; an up gap will surface in the market tops and a down gap in the market bottoms if this is an exhaustion gap. Breakaways, on the other hand, appear as up gaps in market bottoms and down gaps on market tops. Breakaway gaps often result from consolidations.
Best Markets for Gap Trading
Generally, you can use gap trading in any market, including stocks. The trick is to choose the most predictable markets and watch them carefully. You don’t need to use any indicators unless you want to, and you’ll easily find a market that has a price gap between the previous day’s close and today’s open. In most cases, prices tend to move in the direction of the last close, so your opportunities for trading are excellent.
Remember to focus on the day session of the markets and to exclude the overnight session. Of all types of trading strategies, the odds tend to be in your favour when trading gaps although it’s worth bearing in mind that past trends do not necessarily translate into future performance. A key aim is to try to avoid the majority of the losers, as opposed to trying to catch all the winners.
As you don’t need indicators or other sophisticated tools, you can use charting software to plan all your trades. In the forex market, the EUR/USD pair is the most commonly traded no matter which trading strategy you are using. That’s because this major pair benefits from liquidity and is able to withstand shocks to the markets better than other currencies.
RSI, or Relative Strength Index, is a technical indicator used by traders to monitor markets and make wiser investment decisions. RSI works by comparing recent gains and losses in a market in order [...] Momentum traders are similar to trend traders in that they monitor movement in market prices and look for upward or downward trends they can take advantage of. They take either a long or short posi [...]
RSI, or Relative Strength Index, is a technical indicator used by traders to monitor markets and make wiser investment decisions. RSI works by comparing recent gains and losses in a market in order [...]
Momentum traders are similar to trend traders in that they monitor movement in market prices and look for upward or downward trends they can take advantage of. They take either a long or short posi [...]
Best Techniques and Tactics for Forex Gap Trading
Use stop losses when forex gap trading, especially on weekends, and make sure they are adaptive to any recent market volatility, higher volatility is equal to wider stops. You can measure volatility in the forex markets using the ATR (Average True Range) indicator. If you opt to trade forex gaps, it’s best to use wide stop loss orders. This is because there can be significant negative deviation before the gap closes, and sometimes not all gaps are filled. If you enjoy the challenge of weekend gap trading, you should learn to reduce your position sizes accordingly to accommodate the wider exit point. Wider stop losses are better because they can adapt to volatility in the market. If you want to measure volatility, the Average True Range (ATR) indicator may be useful. Bear in mind that the tighter your stop, the more likely it is that you will be stopped out and generate a loss.
For weekend gaps, focus on those major currencies that are most liquid, for example:
You could possibly increase your winning percentage by using profit taking targets at percentages of a gap being closed. For instance, some traders opt to exit half their position at about 50% closing of a gap with the remaining position grabbing an opportunity for a full gap close. Always pay attention to bid/offer spreads which can become very wide during the Sunday evening opening period.
Alternative Trading Strategies
Before adopting any trading strategy, you know it makes sense to look around to see what other alternatives are available. For this reason, before making a final decision about gap trading, you may wish to consider some of the alternatives. Position trading is sometimes described as a buy and hold strategy rather than active trading. You’ll find that this is because it involves the use of a number of methods to determine trends, including longer term charts. Position trading may last from several days to several weeks, or sometimes even longer.
Swing trading focuses on using technical analysis to look for stocks and short-term price momentum. Sometimes, swing traders utilise the essential or core value of stocks and they also analyse trends and price patterns. Scalping involves speedy trades on small movements in price in a single day in order to collect a large number of small gains, gathering them together for a healthy profit. It’s considered safe by many traders because risk exposure is limited. Investors also use breakout trading in order to limit risk levels. They do this by taking a position within the early stages of a trend. You can consider this trading strategy as the starting point for any significant price moves and can also signal expansions in volatility.
Tips for Choosing Your Broker
If you’re serious about gap trading as a strategy, you will want to consider which online brokers will suit you best, as having the best stock broker to serve your individual needs is very important for every investor. It may be that you’re attracted by cheap trades, for example, however you should remember that these often come at the expense of fewer research tools and a very simplified or cumbersome trading platform. Check up on these points before you commit:
- Available trading tools and investment options
- Banking and account security
- Retirement accounts and account minimums
- Speed & order execution and international trading
- The level of trade commissions and other fees
- The quality of market research and customer service
Investigating these features of potential brokers should highlight any areas of concern, as well as any functions that a particular broker does well. Some stockbrokers are specialists in specific areas, such as day trading or options trading, so it’s best to check these out in advance.
For day trading, which is of interest if you like to use a scalping or a gap trading strategy, there are particular facilities to which you will want to pay attention. These include the costs and expenses of trading, even if you are a high-volume trader your gains may not always exceed commission costs. Look for a broker that offers special rates for day traders if you are highly active.
Is Gap Trading the Right Strategy for you?
Gap trading is a precise and disciplined strategy, so if you want to engage with it, you will have to be sure you have a suitable temperament. Vigilance is key and the ability to understand charting and recognise different types of gaps is essential. You will need to take time out to monitor trades before opening a position and to keep a careful watch as time passes. When you fully understand the characteristics of different kinds of gaps you can learn how to navigate them to achieve the best result.
You can use gap trading on any kind of stock and also on the forex markets if you prefer currency trading. In the latter case, it’s safest to stick with the major currency pairs which have the greatest fluidity. It’s always best to check out a range of different trading strategies before deciding on one you prefer, so use demo accounts available from your broker to try your hand at different techniques. Take the time to check out your broker’s track record, especially the costs and expenses you might incur, as this is what will make the difference when it comes to profits or losses.