Gaps are formed when a price imbalance occurs in its buy and sell orders. Most gaps are usually driven by news or economic reports, earnings reports or up/downgrades. The daily gaps are defined in stocks when the day’s opening price (begins at 9:30 am EST) is either higher or lower than the prior day’s closing price at 4pm EST. Most stocks and index futures gap about 20% to 25% of the time during the year.

Although “Gap” trading is very profitable, trading gaps is relatively difficult for many traders. Many traders avoid gap trading as “Gaps” are usually manipulated by professional portfolio traders and large institutional traders. However, experienced traders employ some successful strategies to trade gaps by a popular method of fading them. Traders watch pivots, support and resistance areas within the gaps and fade them.

Additionally, “Gaps” form during intra-day trading (on time-based charts) and may offer some potential clues to price-action. During intra-day trading, gaps formed in higher time frame charts such as 30 minute or 60 minute offer excellent trading opportunities.

Gaps are primarily grouped as: Common, Breakaway, Continuation and Exhaustion. Each has its own way to trade, but the most profitable and relatively low-risk “Gaps” are Breakaway and Exhaustion gaps. Exhaustion gaps present very attractive gains and Breakaway gaps offer low risk setups. Breakaway gaps are also excellent in finding the breakout candidates for long term.

Here are some basic rules to remember when trading Gaps.

  1. Trading “Gaps” is an art and is a specialty by itself.
  2. Gap trading methods offer reasonable success, but it does present more risk than other trading methods. However, gap setups such as breakaway, exhaustion and island reversals offer excellent rewards for the risk involved.
  3. Stocks which involve gap trading must have a consistent trading range. For example, a stock priced at $20 must have at least a $0.50 average trading range (ATR), and a stock priced at $50 must have at least a $1 average trading range. Furthermore, a stock price of $100 must have at least $2 average trading range.
  4. To consider an upside breakaway gap, the stock must be closing lower at least two or three days prior to the gap formation.
  5. Gaps below the markets act as support and above the markets act as resistance.
  6. In most cases, index futures’ opening gaps tend to fill during the same trading day.
  7. Common gap trading should be avoided by most traders.
  8. During Gap trading, protect your trades using trail stops.
  9. A valid breakaway gap almost never gets filled. Hence, all “Gaps” get filled is only partially true.
  10. If a daily stock gap is 2.5 times the 10-day ATR, ignore the trade until at least the following day.

Gap Types

Trading Exhaustion Gap

Trading Exhaustion Gap

The example above illustrates an “Exhaustion gap” setup from the Google’s (GOOG) daily chart. A series of other Gaps are also shown in the example above. From April to May 2006, GOOG expanded making higher highs and traded from $340 to $450. In the middle of April 2006, GOOG released its earnings. Subsequently, GOOG gapped (exhaustion) open from $41 5 to $435 and traded as high as $450. After a few days from the earnings report release, GOOG failed to continue its higher closes and traded below the low of the gap bar at $435 to confirm an Exhaustion gap setup.

  1. Enter a “short” trade below the low of the gap bar at $435.
  2. Place a “stop” order above the high of the gap bar $45 I .
  3. Enter a target near the previous “swing low” prior to the exhaustion gap at $400.

Trading Breakaway Gap

Trading Breakaway Gap

The example above illustrates a Breakaway gap setup from the Sepracor’s (SEPR) daily chart. Breakaway gaps develop from consolidation zones and are not filled for a long time. SEPR traded in a consolidation zone after an extended rally from December to January, 2006. In late January 2006, a Breakaway gap was created as SEPR expanded its trading range to downside from $60 to $57.75.

  1. Enter a “short” trade below the low of the gap bar at $56.
  2. Place a “stop” order above the high of the gap range at $60.
  3. Place a target near the major swing low prior to the rally at $50.