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Education

Types of Trading Gaps

Just because the stock market is closed, doesn’t mean things aren’t happening. Major changes in the price of a stock can occur overnight, resulting in a much different price at the market’s open then there was when it closed the day before. These price differences are called gaps – and they’re what many traders count on to make some money and boost their portfolios.

What Causes Trading Gaps

A trading gap occurs when a large number of people suddenly become interested in buying or selling a stock while the market is closed. This rise/drop in the attention paid to a particular stock is typically influenced by things like after-hours earnings reports or a change in trader psychology.

How Gaps Get Filled

When a gap ends it is said to have been “filled.” This simply means that the price has gone back to where it was before the gap began. If this happens on the same day the gap occurred, it is known as “fading.”

Gaps don’t always fill, but when they do it’s usually because some factor has caused either too much pessimism or optimism amongst traders. For instance, let’s say an after-hours earnings report reveals a company’s increased earnings during the previous quarter. This is an occurrence that is likely to make people want to buy suddenly, causing the stock to gap up. However, as the day goes on, traders may realize that not everything in that earnings report was good. This may result in decreased interest in the stock and a subsequent gap down in its price.

Types of Trading Gaps

There are two broad categories: up and down.

An up gap is formed when the stock reaches a low price after the market closes that is higher than the highest price of the previous day. By contrast, down gaps happen when the market closes and a stock reaches a high that is ultimately lower than the lowest price of the day before.

From here, gaps can be further broken down into four types, depending on their characteristics:

Common Gaps

Gap trading on candlestick chart

Common gaps are, as they imply, somewhat generic. They don’t usually mean anything in particular and often don’t even represent an opportunity to trade. They fill fairly quickly and are simply a blip on the radar of a stock with a low trading volume.

Breakaway Gaps

Increased enthusiasm and a swing toward either significantly more buyers or sellers can cause a stock to gap out of a period of congestion. This is called a breakaway gap and it occurs above a support or resistance area, typically right after a new trend is established. These don’t get filled quickly, especially if they are an indicator of a new trend. In other words, day traders should be patient and avoid trading a breakaway gap as though you are expecting it to fill quickly.

Runaway Gaps

Runaway gaps occur when a large group of traders suddenly adopt a strong opinion regarding the way a stock will behave in the future. This usually happens as a result of seeing some kind of news or report regarding the stock, which experienced traders know isn’t always a good idea. This can happen in both an upward and downward pattern and can result in a bit of a panic for those traders who do not follow the initial trend to buy or sell. Because runaway gaps happen in the middle of a trend, they often don’t fill completely and instead are an indicator that another gap will occur soon.

Exhaustion Gaps

These gaps usually happen at the end of a pattern and often signal a change of trend. Exhaustion gaps behave like runaways  but are set apart by their extremely high volume. This component of trend reversal means that exhaustion gaps are typically filled pretty quickly, as they signal the end of one trend and the beginning of another.

How To Trade Gaps

Like most things in the stock market, there isn’t one right answer when it comes to successfully trading gaps. But, bearing in mind that there is always some risk of failure, those who have mastered this art often find themselves quite successful. Unfortunately, the knowledge of which gaps to trade for how much and when comes from experience and can take months or even years to learn.

You might learn how to successfully trade gaps on your own, but you also might not. Or, you can benefit from the years of hard work I’ve put into being a day trader and take advantage of the day trading classes I’ve created to help fellow day traders save their precious time and money.

I do this because day trading is my passion, and I want to help others make it theirs as well. Sign up for your first class now and you’ll be trading in just one hour. Or, if you have questions, you can click here to learn more about day trading classes or shoot me a message so we can set up a time to chat.