Introduction
Trading gaps are a common pattern in trading and markets, but not many traders know how to trade them correctly. First, we must begin with: What causes them? What are their features? And most importantly, how can you use them to make profitable trades?
In this guide, we’ll answer all of those questions and more. We’ll dive into the four main types of gaps you’ll encounter in technical analysis, explain what they signify, and provide practical strategies for trading each one. By the end, you’ll have a solid understanding of gaps and how to use them.
What are gaps in trading
Let’s start with the basics. What are gaps in trading? A gap is an area on a chart where the price of an asset opens above or below the previous day’s close with no trading occurring in between. Normally, charts depict the price constantly moving with bars, candlesticks, or lines. So when you see a blank space, that’s a gap.
Gaps give clues about the underlying supply and demand dynamics happening in the market. They often represent strong, actionable moves in price that you can take advantage of if you know what to look for. The four main types of gaps are:
- Breakaway Gaps
- Common Gaps
- Continuation Gaps
- Exhaustion Gaps
We’ll explore each of these in detail, but to use gaps effectively in your own technical analysis, you need to understand what makes them happen in the first place.
Why do gaps form?
Gaps occur because of an imbalance in supply and demand for an asset between two trading sessions. This is usually driven by an important catalyst or piece of news.
For example, let’s say a company reports fantastic earnings after the market closes. There could be so much excitement that when the market reopens the next day, a flood of buyers send the price gapping up at the open.
The opposite holds true too. Bad news can cause large sell orders to stack up overnight or over a weekend, leading to a gap down.
Gaps can also form when an asset is thinly traded or illiquid. With not as many shares exchanging hands, even minor imbalances in orders can cause prices to jump from one level to the next.
The size of the gap matters too. Bigger gaps tend to be more significant, while smaller ones can just be temporary blips.
Now, let’s look at how to identify and trade the four major types, starting with breakaway gaps.
Breakaway gaps
Breakaway gaps are one of the most exciting gap types for traders to watch. As the name implies, these gaps represent a clear break from an existing pattern or range in the price. They signal that a new trend is likely beginning.
You’ll often see breakaway gaps after a period of consolidation, like a price moving within a defined support and resistance range. Then suddenly, the asset gaps above resistance (or below support), leaving the previous range behind. This is a powerful move as it takes out key price levels.
Breakaway gaps are marked by high volume, confirming that there is strong interest in the new direction. If you see a breakaway gap accompanied by a large uptick in volume, that’s a solid sign that a new trend could be underway.
How to trade breakaway gaps
To trade breakaway gaps, look to enter a position in the direction of the gap. For an upside breakaway gap, you would go long. For a downside gap, you could short the asset.
One logical place to put a stop loss is on the other side of the gap. So for a breakaway gap up, you could place a sell stop just below the low of the gap candlestick. That way, if the price falls back into the previous range, you’ll get out for a small loss. For a downside gap, a buy stop just above the gap high works well.
Your profit targets can be at key Fibonacci extension levels or simply a multiple of the size of the breakaway gap. For example, if a stock gaps up $5, you could target $10 or $15 above that.
The most important thing with trading breakaway gaps is to have confirmation that it’s a true break. Avoid chasing gaps that are likely to fill soon after. And be sure to manage your risk carefully in case the breakout fails. Waiting for the candle to close is a good way to confirm if its a true breakaway gap.
Common gaps
On the other end of the spectrum from breakaway gaps are common gaps. These are small gaps that happen frequently when the price is trading in a range. They don’t give much information about the future direction.
For example, if a stock has been bouncing between a key support and resistance area, you’ll often see minor gaps form as it moves from the bottom to top of the range or vice versa. But because the price remains within the established channel, the gap is less significant.
Common gaps get filled very frequently, meaning the price will reverse to cover the empty space. So it’s usually not worth trading these gaps, as the edge is minimal.
Instead, you want to focus on trading breakaway gaps in the direction of the new trend or waiting for continuation or exhaustion gaps to develop.
Continuation gaps
Another high-probability gap to trade is the continuation gap. These occur in the middle of an established trend to signal that the trend still has room to run.
In the chart above, Tesla stock has been steadily climbing. Within that broader uptrend, a continuation gap appears. The price gaps up, breaking out of the small range to confirm the trend.
Continuation gaps are a sign of conviction in the current trend. Traders who missed the initial move are anxious to get in on the action and propel the price further in the trending direction.
But here’s the key. To identify real continuation gaps, you want to see strong volume. Average or slightly above average volume on the gap is a good sign that the trend is likely to persist.
Low volume, on the other hand, can be a red flag. Without enthusiastic participation, there’s a chance the gap could actually be an exhaustion gap, which we’ll cover in a minute.
How to trade continuation gaps
To trade continuation gaps, you want to join the trend that’s already in motion. For an uptrend, wait for a pullback after the gap. Then as the price begins to climb again, go long with a stop loss below the recent swing low. Trail your stop or take profits at key levels as the trend progresses.
The same concept applies to continuation gaps within downtrends. Wait for a bounce after the gap down. Then enter a short position as the bounce loses steam and the price starts falling again.
Exhaustion gaps
The final type of gap is the exhaustion gap. This one is tricky because it looks very similar to a continuation gap at first. But rather than confirming a trend, exhaustion gaps hint that the trend is nearing its end.
Exhaustion gaps represent a last, desperate push by traders to jump onboard a trend. It’s FOMO in action. This surge in activity creates one final gap in the direction of the trend. Traders who buy this gap are usually exit liquidity for others who have already got in much earlier.
Use indicators like the RSI indicator or stochastic to avoid trading any gaps when the price is overbought or oversold. Remember that if the trend has already gone on for a long period of time then the chance of it being an exhaustion gap increases more and more.
Clues that a gap might be an exhaustion gap include:
- Extremely high volume, even a climactic surge compared to prior gaps
- A rapid fill of the gap or even a same day/session fill
- The price stalling out and reversing soon after the gap
Reverse trading exhaustion gaps
If you can spot an exhaustion gap in real time, it provides a fantastic opportunity to trade the reversal. Once you have confirmation that the gap was likely an exhaustion gap, you can enter a counter-trend position.
For an exhaustion gap after an uptrend, wait for the gap to fill then look to go short when a bounce fails. Set a stop loss above the high of the exhaustion gap and target key support levels that could get tested as the new downtrend takes hold.
Conversely, you could buy an exhaustion gap after a prolonged downtrend. Wait for a break back above the top of the gap. Then enter long as the nascent uptrend starts accelerating. A stop under the exhaustion gap low contains your risk.
Trading gaps – concluding
Let’s quickly review the four key gap types and how to trade them:
- Breakaway gaps occur after a price breaks out of a range or congestion. Trade in the direction of the gap with high volume for confirmation.
- Common gaps happen often during sideways markets. They aren’t worth focusing on.
- Continuation gaps represent a trend that’s likely to keep going. Join the trend on a pullback after the gap.
- Exhaustion gaps can trick you as they look like continuation gaps at first. But they actually signify a last gasp in a trend. Trade the reversal once you see follow-through after the gap.
Whenever you see a gap on a chart, take note of the context, volume, and how the price reacts immediately after. Then classify what type of gap it is and look for an appropriate trade setup if one emerges.
While gaps are powerful tools, always use them in conjunction with other methods of technical analysis. Trendlines, moving averages, support/resistance and chart patterns can all help confirm your gap trades.
Most importantly, always control your risk when trading gaps. They can be emotional environments with quick spikes in volatility. Make sure to size your positions properly and set clear stop losses to avoid any outsized losses.
You can learn all about gaps and other technical analysis methods by signing up for our beginner trading course. Now 60% off!
