I love trading off gaps. I trade off them to make mincemeat out of the SPY. And today, I’m going to teach you some simple to learn techniques that will make you significantly better at trading gap plays.
You will learn :
- What is a market gap
- How to apply gap rules
- Understanding risk levels
- Where to get into the trade
- How to successfully exit the trade
You may already know that gap trading is a highly successful and lucrative part of your trading tools.
Unfortunately, gaps are also highly damaging to trading accounts more frequently than led to believe.
Many traders believe gaps are typically used for intraday stock trading and overlook using these techniques for daily charts.
It’s not as simple as running out and trading any stock on a daily timeframe. If you look at Daimler, the German automotive manufacturer, it may seem like the perfect stock to trade since it gaps frequently.
See, this chart experiences gaps almost daily. And you don’t want to trade this for liquidity reasons (at least five more reasons, too).
But why can’t I trade this if it’s listed in the US? Well, you can, but it’s meant for longer-term investments instead of trading using the ADR.
What is an ADR, and why does it matter?
An American Depository Receipt (ADR) is a certificate issued by the U.S. depository bank representing a specified number of shares invested in a foreign company’s stock.
DDAIF is an ADR of Damlier, the German automotive manufacturer, trades on the Deutsche Boerse AG German Stock Index (DAX).
An ADR allows U.S. investors access to otherwise limited international marketplaces. This ADR does not trade on the U.S. exchanges, but is instead a reflection of the underlying asset in their respective exchange. For the most part trading gaps on an ADR is outside the scope of this article.
So now let’s take a look at where the real interesting gap plays are since we know not to look at ADR’s anymore.
Filling The Gaps
Gaps are a strong indicator and best if used as technical support or resistance levels.
Due to the traders that are caught on the wrong side of the trade, many gaps have a tendency to be filled.
Here is an example of an extreme gap fill that occurred over the course of several weeks.
What a crazy move, right?
It carried so much momentum along with it that the stock proceeded to also run to 52-week highs!
And there are trades like this happening every day!
Around here, we like to trade the SPYs.
Let’s see if this theory will work over there, as well.
Trading Market Gaps
Trading gaps in major markets on daily timeframes is substantially less risky from standard gap strategies.
Trading gaps of over 30% caused by M&A activities makes the SPY seems relatively dull.
That’s because many traders treat this as a casino of thrills and excitement.
Less volatility = Less risk
By looking at gaps as areas of support in a Continuation gap, you can easily see how pacing our trades at these levels provided nearly 100% winning trades!
Here is a chart of a perfect breakaway gap /continuation gap combo recently seen in the SPYs!
It’s important to notice how the price filled the gap and continued its uptrend.
That’s because the gaps are acting like support zones for the buyers to step in.
Pro tip: The secret here is the Continuation gaps AFTER the Breakaway gap!
Where do you exit the trade once you entered?
The beauty of trading gaps is it has a built-in target for the stock as well. Since gaps usually like to be filled in both directions you can use the gap as a target.
It’s that easy to find entry and exit prices all in a single setup!
Putting it all together
So that’s it – nothing here is rocket science. Instead, it is a little of this and some of that.
Key points to remember:
- Gaps like to be filled
- Treat gaps as support and resistance zones
- Continuation gaps after a breakaway gap to be the most powerful
Now get out there and trade those gaps!