There’s nothing I love more as a trader than a good gap.
A gap is an area where the price of a stock moves sharply up or down from the previous close. Gaps occur because of fundamental or technical factors that are influencing the market.
They are typically found around periods of news or earnings that drive the price away from where it closed the day prior. For example, if a company’s earnings are much higher than expected, the company’s stock may gap up the next day.
SFIX gapped up the following day after a positive earnings release this week.
For day traders, a gap is a highly anticipated momentum signal. Every day, these traders have the same focus… find the biggest gappers, search for a catalyst, add to a chart in their grid, and execute trades when momentum picks up.
Of course, I mainly do swing trading across my trading services, so I always look forward to that overnight gap up.
Here are two categories of gaps that we can trade.
- Gap Continuation
- Gap Fading
Today, I want to talk about 2 continuation gaps we can trade… tomorrow, I’ll share 2 fading gaps.
Each of the gaps have wildly different outcomes from one another.
Get our analysis incorrect, and we could be placing ourselves on the wrong side of the markets with very little time to exit the trade.
Allow me to share 2 continuation gaps that I like to look for…
Breakaway gaps are typically found at the very end of a price pattern and are typically seen as a shock to traders.
These gaps are typically found when a pattern is coming to a conclusion and buyers (or sellers) stepped in and started the next trend cycle.
In this example, the major triangle pattern is finally being invalidated by traders and a new direction is being declared.
Continuation Gaps :
Continuation gaps are also known as runaway gaps.
These gaps occur in an already existing pattern signaling a rush of buyers (or sellers) who believe the stock is continuing the current trend.
This is typically fundamentally driven and has outside influences other than technical trading patterns. It is usually assumed that cash inflows are being rushed into the stock from major investment banks or institutions trying to get on the bandwagon.
Trading the Gap
Now that each gap is identified, let’s take a look at how we can trade the continuation gap.
Each trader has their own idea of why a gap was formed and which direction it should take.
Every gap tells its own story and therefore bears a different meaning to each trader who analyzes it.
Gap continuation is a trade that continues in the direction of the gap. Usually gaps will continue their trend only when it’s a healthy market and the primarily buyers (or sellers) want to remain in control.
Breakaway gaps and continuation gaps are typically the only two gap patterns that will have continuation in their price action.
Pro Tip: institutions and large hedge funds will tend to pile into stocks when there is a healthy trend causing these gaps to occur or continue.
That’s why scanning for activity in the dark pools is a big part of my overall trading strategy.
Filling The Gap
Is it common for gaps to be filled? Yes and no.
Depending on the type of gap and the strength of the move, it’s possible for a gap to be filled. Both of those factors will determine if the gap can be filled that same day or if it will require more time. The speed at which a gap is filled usually depends on the ‘shock’ the gap produced in the chart.
Pro Tip: Some gaps are so strong that they can destroy technical patterns and invalidate setups.
Why are gaps filled?
It’s important to remember that gaps are caused by emotion. Due to human emotions there are many different factors that impact a stock. It’s always hard to know if a stock will fade from the open or just continue in the new direction. When a gap is filled it usually boils down to a handful of reasons.
Gaps are filled from 3 major reasons:
- Irrational exuberance
- Technical resistance
- Price patterns
Irrational exuberance :
When the initial spike in price may have been overly optimistic from FOMO traders getting into the breaking news. They are exiting the trades with either a quick profit or after they have realized they made the wrong decision.
Technical resistance :
Common when a price moves up sharply. If a stock gaps up into technical resistance, it has a higher probability of reversing and filling the gap to the downside. Some examples of technical resistance are trendlines, technical patterns, support and resistance zones, 52-week high and lows, etc.
Price Pattern :
This one is important since it gives the trader the “bigger picture” as to what the stock should be doing. Price patterns are typically used to identify exhaustion and continuation gaps.