An Introduction to Gap Trading Strategies
Are you interested in trading gaps but unsure how to interpret them? Gaps are a crucial part of a trader’s toolkit, offering unique insights and opportunities in the market. However, understanding and using them effectively can often seem challenging.
This article provides a comprehensive guide to understanding gaps and practical examples of trades using market gaps.
Key Takeaways
A trading gap is a “jump” in the market, either upwards or downwards.
Gaps can appear within a trading session (intraday gap) or from one session to the next (overnight gap).
There are four types of gaps—common, continuation, breakout, and terminal—each linked to specific market conditions and trading signals.
A gap is considered “filled” when the price returns to its level at the start of the gap. However, it’s important to note that not all gaps are filled.
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What is a Trading Gap?
A trading gap represents a break in market price movements. It occurs when imbalances between buyers and sellers cause prices to jump significantly, either up or down.
This results in a visible empty space on the price chart.
This screenshot displays a trading gap in the NASDAQ Composite index, observed through the ProRealTime Trading Simulator. It shows a significant price jump of +247 points from the start of the gap at 13,767.74 points to the end of the gap at 14,015.37 points, with no intermediate trading.
Use an appropriate chart format, such as bar charts or Japanese candlesticks, to observe trading gaps. Gaps will not be visible on continuous line charts (linecharts).
Understanding Gaps
Gaps occur due to a discrepancy between selling offers and buying requests at a specific moment in the market.
This imbalance in the order book typically arises when new information is released, potentially leading to increased market optimism or pessimism. It can also result from shifts in investor perspectives from one trading session to another (such as overnight or over the weekend).
When prices return to the starting point of the gap and fill the previously empty price space created by the sudden appearance of the gap, the gap is considered “closed”. However, it’s important to note that not all gaps are closed; some remain open indefinitely!
Intraday vs. Overnight Gaps: What are the Differences?
Intraday gaps are observed within the same trading session, while overnight gaps occur between one trading session and the next, marked by a difference between the closing price of one session and the opening price of the next.
The more liquid a market, the less likely you are to see an intraday trading gap. This is because many buyers and sellers are in liquid markets, and many orders are already waiting at each price level.
Exploring the Different Types of Trading Gaps
There are four main types of trading gaps in the stock market: common gaps, continuation gaps, breakaway gaps, and exhaustion gaps. As you will see, each one of them can be interpreted differently.
Common Gap
The common gap is the most frequent type of trading gap seen in financial markets. It is usually small and incidental and is typically filled quickly. This means that the price of the security or index typically returns to its level before the gap occured, and this adjustment happens within a short period of time.
Example of a common gap on the Dow Jones Industrial Average from the ProRealTime Trading Simulator. This common bearish gap is quickly filled by the market.
Continuation Gap (Runaway Gap)
A continuation gap, or runaway gap, typically appears in the midst of a prevailing trend. It represents a sudden acceleration in the market that aligns with the direction of the trend and is usually accompanied by high trading volumes.
Observed on the Dow Jones Industrial Average via the ProRealTime Trading Simulator, this bullish continuation gap is part of an overall upward trend with a total amplitude of +22.72%.
Breakaway Gap
A breakaway gap occurs at the very start of a trend movement. Often associated with the release of significant economic news, this type of gap is accompanied by high trading volumes and signifies the beginning of a new trend.
Example of a breakaway gap on the Dow Jones Industrial Average observed through the ProRealTime Trading Simulator. This bearish breakaway gap marks the beginning of a decline of -37.10%.
Exhaustion gap
The terminal gap typically appears at the end of a trend. It is often linked to buyers’ overconfidence at the end of an uptrend or to excessive pessimism among sellers at the close of a downtrend.
Example of a terminal gap on the Nasdaq Composite index extracted from ProRealTime Web Simulator. This gap marks the end of the uptrend and the start of a downtrend.
This table provides a comparison of the different gap types and trading signals:
| Type of gaps | Gap Size | Trading Volumes | Trading Signal |
|---|---|---|---|
| Common Gap | Small | Moderate | No particular signal |
| Continuation Gap | Large | High | Trend continuation |
| Breakaway Gap | Large | Very high | New trend starting |
| Exhaustion Gap | Large | High | Trend reversal |
Gaps aren’t foolproof predictors of future price movements. High volume tends to confirm the significance of a gap. Always consider them as part of a broader analysis, especially when trying to identify stocks for day trading.
How to trade gaps
To effectively trade gaps, follow this three-step process: first, identify the type of gap you are dealing with; second, assess the market context surrounding the gap; and third, prepare and execute a trading plan.
Traders who use the gap-filling strategy expect prices to return to where the gap started. They place orders at this price, hoping to profit when the price moves back.
When trading continuation gaps, traders quickly enter a position following the trend. They place their stop-loss order just before the gap’s start, assuming the gap won’t fill, and set a take-profit order to secure gains from the ongoing trend.
Example of a buy position following the appearance of a continuation gap on the Nasdaq Composite index, from the ProRealTime Trading Simulator. The trader enters the position when the gap appears (indicated by the black line), sets a stop-loss order below the gap (shown by the red dotted line), and places a take-profit order at a higher point (marked by the green dotted line).
When trading breakaway gaps, traders quickly enter a position in the new trend’s direction as it appears. They place their stop-loss order just before the gap’s starting point, on the assumption that the gap will not fill, and then aim to capitalize on the emerging trend for as long as possible.
Example of a short trade following the appearance of a bearish breakaway gap on the Nasdaq Composite index from the free ProRealTime Web platform. The trader enters the position after the gap appears (black line), sets a stop-loss order above the gap (red dotted line), and places a take-profit order at a lower level (green dotted line).
When trading terminal gaps, traders wait for the price to start filling the gap. This suggests a potential return towards the price before the gap appeared.
Example of a short trade following the appearance of a bullish terminal gap on the Nasdaq Composite index, observed through the free ProRealTime Web platform. The trader enters the position after the gap appears (black line), sets a stop-loss order above the high point (red dotted line), and places a take-profit order at a lower level (green dotted line).
Some trading strategies, like news trading, aim to predict the occurrence of bullish or bearish gaps by anticipating market surprises. However, while these strategies can lead to significant profits, they also have high risks.
Mind the Price Gap Risks
Gaps create uncertainty in the markets and pose risks for traders and investors. While it’s possible to profit from a favorable gap, it’s equally possible to suffer from an unfavorable gap, which can lead to significant capital losses or even debt if leverage is used.
Stop-loss orders, which are set to automatically cut a trader’s losses beyond a certain price level, may not work in the event of a gap.
Indeed, a stop-loss order is simply a trigger-based order—essentially a market order activated when a predefined price level is reached to liquidate the trader’s position automatically.
However, the activation of an order does not guarantee its execution.
The automatic market order may not find a counterparty at the defined safety threshold. It might only be executed much later when the gap ends, and the order book can provide a counterparty for the trader again.
Some brokers offer guaranteed stop-loss orders to protect their clients from the risk of gaps. This protection usually comes at a cost (either direct or indirect), but it can prevent a lot of unpleasant surprises.
Identifying Market Gaps with Screeners
Some traders build their strategies around detecting gaps to either capitalize on their trading signals or bet on their closure. To identify such opportunities, they use screeners—highly customizable market filters.
At any given moment, traders have an updated list of assets that show a trading gap that meets the criteria previously set by the trader (such as size, volumes, and direction).
Although they are common in the markets, trading gaps can catch some beginner traders off guard and cause serious damage. More experienced traders, however, know how to protect themselves effectively and can even seek to profit from them.
Training on a trading simulator allows traders to prepare for the occurrence of gaps and refine their risk management rules accordingly.
Maxime holds two master’s degrees from the SKEMA Business School and FFBC: a Master of Management and a Master of International Financial Analysis. As founder and editor-in-chief of NewTrading.fr, he writes daily about financial trading.
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