Learning how to trade the gaps is a great tool for any investor to have. Like other forms of technical analysis gaps have a very predictable and, thus, trade-able pattern. Here I will bring several gaps to light and how to go about trading them.
Just a basic overview, gaps occur when the opening price is different from the closing price. Gaps happen in most stocks almost everyday. What we will be focusing on is the gaps that gap above yesterdays high or yesterdays low. These gaps are more significant so our time will be spent on these.
First we have the breakaway gap. Breakaway gaps are formed after a period of consolidation and then a strong gap in price.
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| Breakaway Gap |
Here we see a nice consolidation and finally the buying becomes strong enough to gap the price up. From there we see a nice run. This gap takes a non-trending stock and moves it to a trending stock. As a confirmation of the breakaway gap we want a nice spike in volume.
The island reversal is bit of a rare pattern so when it happens it makes a strong signal to trade on. A gap is created, it moves to sideways trading, and then it gaps in the other direction and continues to trend that direction. Lets show some examples:
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| Island Reversal |
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| Island Reversal |
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| Island Reversal |
The thing to notice about the island reversal is that the second gap need to be in the same general area as the first gap. This creates a strong force back in the opposite direction of the first gap.
Gaps create a strong support/resistance points where the old price was and the new price is. These make for good entry points when they are broken and good exit points when they are hit. A big gap creates an area void of price action which allows the stock to move freely without in between with little resistance/support. There are a couple of ways to play these gaps. First you can play the gap in the opposite direction of the gap or when the gap is filling. Then you can play the gap when it has filled, or when it has reached the original price it gaped from. Here are some examples of both of these plays in action:
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| Gap Filling |
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| Gap Sell Off |
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| Gap Fill & Sell Off |
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| Gap Fill & Sell Off |
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| Gap Sell Off |
As you can see gaps display pretty predictable price behavior. The allow for easy price entry, stop-losses, and target points. You may not always get a reversal after a gap fill but if you want to stay in the trade then remember to tighten your stop-losses or go ahead and scale out and take some profits off.
Don't want to swing trade gaps? You can also day trade gaps, and there are several ways to accomplish this. You can go in the direction of the gap or you can fade the gap. If you go in the direction of the gap you look for a high or low to be put in and trade on a break of that price. If you wish to fade the gap, go in the opposite direction of the gap, then you want to put in a market order for the opposite direction of the gap.
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