GAP Trading Strategies
In this article, I will discuss How to Day Trade with Five GAP Trading Strategies. Please read our previous article, where we discussed the VWAP Trading Strategy in detail. You will understand the following pointers in detail at the end of this article.
- What is the GAP Trading Strategy?
- Why do Prices GAP up?
- GAP acts as Support and Resistance
- Types of Gap Trading Strategy
- What is the breakaway GAP?
- Why does the breakaway GAP occur?
- Runaway (or Measuring) GAP
- Exhaustion GAP
- Professional GAP Trading Strategies
- Gap Trading Strategies Summary
What is Gap Trading Strategy?
Gap trading is a strategy used in financial markets that involves capitalizing on the price gaps that occur between trading sessions or after the release of significant news or events. Price gaps are areas on a chart where the price of a stock (or another financial instrument) moves sharply up or down, with little or no trading in between. Traders focus on these gaps as they can indicate potential trading opportunities.
The difference between two consecutive candles’ closing and opening prices is called the gap. A gap occurs when prices skip between two trading periods, skipping over certain prices. A gap creates a void on a price chart. Price gaps are simply areas on the chart where no trading has occurred.
Why do Prices GAP up?
- Gaps Greatest imbalance between demand and supply. The gap is up because of the aggressiveness of buyers. I mean, there are more buy orders at the open than there is available supply at the prior day’s closing price. The gap is down because of the aggressiveness of the sellers. There are more sell orders at the open than willing demand at the prior day’s close. Therefore, gaps are almost always at price levels with a supply and demand imbalance at the open.
- Gaps also occur due to the participant’s overnight sentiment or big news.
- Smart money is trying to skip important support and resistance levels, i.e., If they are bullish, they GAP up price above the supply zone.
GAP acts as Support and Resistance
The Up gap acts as a support zone, and the down gap acts as a resistance zone. The chart below of RELIANCE stock shows the GAP up acting as support for prices.
The Gap fill
The gap-fill refers to the price retrace and close the level where the origin of the gap occurs. The closure rate (gap-fill) for up gaps increases if the prior day’s open-to-close price trend increases. The closure rate (gap-fill) for down gaps increases if the prior day’s open-to-close move is downward.
After the GAP, the price tries to fill the gap. Another occurrence with gaps is that once holes are filled by price, the gap tends to reverse direction and continue in the direction of the gap (for example, in the chart BELOW of RELIANCE, back upwards).
Types of Gap Trading Strategy
Gaps are divided based on the context in which they appear.
- Breakaway (or Breakout) Gaps
- Runaway (or Measuring) Gaps
- Exhaustion Gaps
- Professional gap
- Inside gap
What is the breakaway GAP?
The breakaway gap means breaking the important support or resistance or significant trend line in the form of the gap. Generally appears after completion of important patterns like price in consolidation range or any continuation or reversal pattern. In maximum time, this gap does not fill quickly or on the same day. The most important volume should be high.
Why does the breakaway gap occur?
The smart money knows exactly where these resistance areas are. If the smart money is bullish and higher prices are anticipated, the smart money will certainly want a rally. The problem now is how to avoid the old resistance.
- Gapping up through an old supply area as quickly as possible is an old and trusted method – avoiding resistance.
We now have a clear sign of strength. Smart money does not want to have to buy the stock at high prices. They have already bought their main holding at lower levels.
Smart money knows that a breakout above an old trading resistance area will create a new wave of buying. How?
- Many traders who have shorted the market will now be forced to cover their poor positions by buying.
- Many traders are looking for breakouts to buy.
- All those traders who are not in the market may feel they are missing out and will be encouraged to start buying.
Here, you can see that prices have been quickly up moved by smart money, whose opinion of the market is bullish. We know this because the volume has increased. It cannot be a trap-up move because the high volume supports the move.
The chart study above shows breakaway gaps through important support and resistance levels. Every breakaway gap leads to a trend continuation as well.
Runaway (or Measuring) Gap:
After the move has been underway for a while, prices will GAP somewhere around the middle of the move. This gap is called the runaway gap. In an uptrend, it is a sign of continuation of a trend; in a downtrend, it is a sign of continuation of the trend.
You will find that weak gap-ups are always Gap up to resistance or gap down to support. This price action is usually designed to trap you into a potentially weak market and a poor trade, catching stop-losses on the short side and generally panicking traders to do the wrong thing.
Near the end of an uptrend, the exhaustion gap occurred. However, that upward gap quickly fades, and prices turn lower. When prices close under that last gap (exhaustion gap), it is usually a dead giveaway that the exhaustion gap has appeared. An exhaustion gap occurs with extremely high volume.
Professional GAP Trading Strategy:
These gaps appear at the beginning of the moves. Generally, it occurs in the supply or demand zone. (Gap up from demand zone and gap down from supply zone) when price approaches the quality supply and demand zone
Inside GAP Trading Strategy
Inside gaps are gaps happening inside the prior day’s range.
- Week market gap up
- Strong market gap down
However, low volume warns you of a trap up-move (which is indicative of a lack of demand in the market) after a gap up resistance
Gap Trading Strategy:
There are three factors to monitor to determine whether the gap is real or trapped. The three factors are volume, opening price, and pullback
Opening Price and Pullback
After a gap up, the pullback to be watched
- Flat pullback (price consolidates high of the day). Strong buy signal
- The weak pullback was unable to close below the previous day’s high. buy signal
- Strong pullback closes below the previous day’s high. sell signal
If the stock gaps up and then sells off and remains beneath its opening price after the morning pullback has stabilized, the stock may have reached its high of the day. however, if a stock gaps up and pulls back during the morning pullback but then rallies to break above its opening price, the mark-up was probably not trapped GAP, and the stock should make new intraday highs
- It is important to watch the volume carefully when determining if a gap is valid. If the stock GAPs up high, the volume is also high, and the price remains above its opening price after the early morning pullback, it is an excellent sign that the stock has further to go on the upside. All reverse for a trap gap up
- If high volume appears after a gap up and the stock immediately comes under selling pressure, chances are that this volume was a seller.
- If a large volume of paper a gap up the situation and the stock runs higher, then chances are that it was a buyer, probably the reason for the gap up in the first place. The smart money will support the stock if he has the buyer, or he will sell stock quickly if he has the sellers. Smart money does not generally chase the stock in the direction of the gap in the early morning unless there is a fundamental reason for doing so
Our entry is based on two types of gap
- Outside gap(market open outside of the previous day range)
- Inside gap(market open inside of the previous day range)
1. Gap and GO Trading Strategy
All gaps are not filled in that day
Gap and GO Trading Strategy criteria
- The price GAP up above the previous day’s high
- Wait for the first candle to complete
- Volume should be high and supporting in the direction of the gap
- Mark opening range
- Entry on breakout of high of the day
- The price should be above VWAP.
2. Gap-fill reversal Trading Strategy
When a market gaps up, then the gap acts as a support level for any pullback. Pullback Tests of gaps on lighter volume tell that the issue does not have enough energy to get through the gap; instead, the gap becomes support, and our buy entry triggers any bullish signal
- Wait for the price gap to go up
- Please wait for a stock to pull back to its prior day’s close and fill the gap.
Two types of Pullback
- The price gap is up just above the previous day’s high or below the previous day’s low, and then a strong pin bar is formed, which fills the gap. volume should be high on the pin bar.
- The second price gap is up, and then retrace and fill the gap. it takes more than 2 candles, and the volume should be decreasing.
- You then wait to see a sign of strength and enter the position on that move.
- Price should not close inside the previous day in any five-minute candle.
- You then place a stop below the low of the candlestick.
3. Open Gap Reversal Trading Strategy
These patterns generally appear at the top or bottom or in any strong supply or demand zone.
The open gap reversal process
- The chart needs an extended uptrend for at least a few trading sessions to the supply zone. A gap up in price to quality supply zone is a VERY high odds shorting opportunity.
- Or a GAP up in price to quality supply zone in a downtrend is a VERY high odds shorting opportunity.
- After a GAP up, the price started falling and crosses yesterday. This generates the sell.
- The Stop-Loss is the low of the same day.
NOTE:-As we are trading against the gap, more confirmation is required confirmation, either from price action or volume action
4 & 5. Inside GAP Trading Strategy
Let’s analyze a downtrend, and the previous day was a downday. Today’s price gap is up but close to the previous day’s range. Our entry opportunity will be
- Gap up short
- Gap up long
In the context of a downtrend, a gap up in price is a VERY high odds shorting opportunity if any bearish reversal signal is given. A gap up in price, in the context of a downtrend, is a lower odds buying opportunity.
If the stock gaps up and then sells off and remains beneath its opening price after the morning pullback has stabilized, the stock may have reached its high of the day. however, if a stock gaps up and pulls back during the morning pullback but then rallies to break above its opening price, the mark-up was probably not trapped gap, and the stock should make new intraday highs
In an uptrend, entry opportunities will be
- Gap down long
- Gap down short
Gap up short in a downtrend
- Context downtrend
- Wait for at least 5 minutes. Or mark the opening range
- After the 5 minutes, wait for a reversal price signal to provide short-term confirmation that the markup was a trap by smart money and the short-term trend is pointing downward.
- The short below the first candle
- Volume should be below. If the stock has a GAP up high, the volume should be high to confirm the real gap. However, if the price closes below the opening price with no large volume, chances are that the mark-up was a trap by smart money.
Let’s analyze the gap down long in an uptrend
Gap up long in a downtrend
How to know whether the gap up is real or trapped by smart money
- When the gap opens, the volume should be heavy to go higher. if smart money is actively supported by volume
- Wait and see if the market trades above its opening prices after the morning pullback. It indicates the gap was real
- Then go along
- Or you can enter from a previous day’s low when the price retrace test of the previous day’s low.
Note: – This entry technique is very risky as we are going against the trend and momentum, so double confirmation is required
Combining our Pullback Trading Strategy and the Advance CANDLESTICK Analysis article is very useful for this trading strategy.
Gap Trading Strategies Summary:
Gap trading strategies revolve around the principle that price movements will eventually fill the gap. A “gap” in trading refers to a sharp break between prices on a chart where no trading occurs, resulting in a visible discontinuity. This typically occurs between the close of the market on one day and its opening on the next. Gaps are often caused by economic data, earnings reports, or other significant news events that occur when the markets are closed.
Types of Gaps
- Common Gaps: These occur without any major news or events and are typically filled quickly.
- Breakaway Gaps: Occur at the end of a price pattern and signal the beginning of a new trend.
- Runaway Gaps: Also known as continuation gaps, occur in the middle of a trend and signal its continuation.
- Exhaustion Gaps: Occur near the end of a price pattern and signal a final attempt to hit new highs or lows.
Gap Trading Strategies:
- Gap and Go Strategy: This involves identifying stocks with significant gaps at the market opening and trading toward the gap. Traders look for high volume and significant news to validate the gap.
- Gap Fill Strategy: This strategy is based on the observation that prices often “fill” the gap. A trader would buy or sell, expecting the price to return to its previous level.
- Breakaway Gap Trading: When a gap occurs with strong volume and after a period of consolidation, it may indicate the start of a new trend. Traders might enter a position in the direction of the gap.
- Runaway Gap Trading: In a strong trend, a gap can indicate further movement in the direction of the trend. Traders might use these gaps to add to their positions.
- Exhaustion Gap Trading: These are identified towards the end of a trend and might signal a reversal. Traders might look for low volume and other indicators to confirm.
When using gap trading strategies, here are some important considerations:
- Volume: A high volume after a gap is generally seen as a confirmation that the gap will not be filled immediately and that the new price represents a new consensus on value.
- Context: The underlying reason for the gap should be considered. For instance, a gap caused by a major fundamental shift in the company’s outlook (like a merger or an acquisition) is less likely to be filled than a gap caused by short-term factors.
- Time Frame: Some traders look for gaps on daily charts, while others look for intraday gaps within the trading day.
- Risk Management: Using stop-loss orders when gap trading is critical because the price can move quickly and unexpectedly after a gap.
Limitations and Risks of GAP Trading Strategies
- False Signals: Not all gaps lead to predictable outcomes. Sometimes, gaps don’t get filled as expected, or the trend doesn’t continue as projected.
- Market Volatility: Gaps often occur in volatile market conditions, increasing the risk of trading.
- Overnight Risk: In some cases, holding a position overnight to capitalize on or wait for a gap to fill can be risky, especially if unpredictable events occur.
In the next article, I will discuss the Intraday Open High Open Low Trading Strategy in detail. Here, in this article, I try to explain How to Day Trade with GAP Trading Strategies in detail, and I hope you enjoy this GAP Trading Strategy article. Please join my Telegram Channel, YouTube Channel, and Facebook Group to learn more and clear your doubts.
About the Author: Pranaya Rout
Pranaya Rout has published more than 3,000 articles in his 11-year career. Pranaya Rout has very good experience with Microsoft Technologies, Including C#, VB, ASP.NET MVC, ASP.NET Web API, EF, EF Core, ADO.NET, LINQ, SQL Server, MYSQL, Oracle, ASP.NET Core, Cloud Computing, Microservices, Design Patterns and still learning new technologies.