A fascinating method that many skilled traders are now employing is making use of large jumps in stock prices by turning this volatility into opportunity. An enterprising trader can exploit these jumps, called ‘Gaps,’ and make profitable trades.
The concept is surprisingly simple but executing this strategy is a whole other thing. However, many investors have successfully achieved strong returns due to investing in gap-fill stocks.
What is a Gap?
In stock trading, a gap is when the price chart on stock moves sharply up or down with minimal trading taking place in between. Therefore, the stock chart shows a gap in the regular price pattern. Smart traders can take advantage of these gaps and make profits.
Gaps occur due to underlying fundamental or technical factors. They are anomalies in stock price behavior followed by predictable price movements, which can become an opportunity for savvy traders to make a profit.
Usually, the pricing information visible on a chart is continuity, even with high volatility. There is a similarity between the previous day’s close and the new day’s opening. When the closing and opening prices are so different that they are not even connected in the chart, it is referred to as a gap.
What are the Types of Gaps?
There are four distinct categories of gaps on stock price charts. The type of gap determines the trading strategy investors will take.
- Breakaway Gaps- When gaps occur at the end of a price pattern and signal the start of a new trend, it is called a Breakaway gap.
- Exhaustion Gaps- occur near the end of a price pattern and are usually the signal of the last attempt at reaching a new high or low.
- Continuation Gaps- Also known as runaway gaps, are found in the middle of a price pattern when investors have a sudden change in belief about the stock’s future direction.
- Common Gaps- These gaps do not fall into price patterns; they are formed because of normal trading activities.
To take advantage of a gap in the pricing of a stock, it is imperative that you correctly identify the gap and apply the appropriate trading strategy suited for it.
What is a Gap Fill?
Gaps are mainly temporary situations, and most of the time, they are ‘Filled.’ Filling here means the price is back to its pre-gap amount.
In a few cases, this occurs because the influx of buyers and sellers who flocked to the stock are rethinking their positions, or investors see an opportunity in the extreme price, and in the end, they cause the price to correct itself.
Gaps are also filled due to the presence of technical resistance. The existing support or resistance thresholds are no longer valid due to the sudden price change. This is often unsustainable, and the gap is filled.
The type of gap also determines whether it will be filled. Breakaways confirm the direction of the pricing trend and thus cannot be filled. However, exhaustion gaps are at the end of a pricing trend and are more likely to be filled.
Do All Gaps Fill?
A gap is said to be filled when it reverts to its original pre-gap level. Most gaps are filled, but there are a few that do not. Low volatility stocks such as penny stocks will sometimes never fill a gap.
If a gap is being filled on the same day it was created, it is called ‘fading,’ This happens when overnight news makes a gap, and later news kills the gap, or if cooler heads prevail and the price returns.
The filling usually occurs due to three reasons:
- Support and resistance– the stock price is pushed back due to technical resistance.
- Over Zealous- A correction occurs after irrational exuberance due to over-optimism or over-pessimism.
- Exhaustion Gap- This price pattern will usually be filled as it signals the end of a price trend.
Intelligent investors should attempt to identify the gap instead of trading while assuming that all gaps will be filled. Common gaps can occur for multiple reasons and also for no reason whatsoever and thus are always filled, and they rarely impact the overall trend.
Exhaustion gaps are almost always filled as it signals a reversal of the trend, and they are marked by a wide gap between trading periods and an increase in trading volume.
Continuation gaps are usually filled later, but it takes a while to do so. They are seen amid a well-established trend, and they occur when company-related news has a positive or negative reaction from investors.
Breakaway gaps confirm the direction of a trend and are the least likely to be filled and most likely to be misidentified. Many investors will misidentify other gaps to break away gaps and use the wrong strategy.
It is important to remember that almost all gaps are filled eventually. Gaps respond to specific circumstances, and when the change has passed or when investors become accustomed to the new events, the stock prices will settle back.
How to Trade Gap Fill Stocks?
Multiple strategies can be employed to take advantage of gaps. Some traders will trade when technical or fundamental factors favor a gap; for example, they will buy a stock after hours when a positive news report is released, hoping for a gap up on the following day.
Traders can also buy or sell into highly liquid or illiquid positions at the start of a price movement, hoping for a fill and continued trend. For example, they can invest in a stock gapping up quickly on low liquidity and no resistance.
After determining a high or low point, other traders will use technical analysis to fade gaps in the opposite direction. For example, if a stock gaps up due to some speculative new report, savvy traders may fade the gap by shorting the stock.
Traders can also buy a stock after the gap has been filled and the stock price reaches the previous support level; this is when prices are likely to trend upwards.
The following are a few key points to keep in mind:
- Due to the lack of support or resistance, once a stock has begun to fill the gap, it will not stop.
- Exhaustion gaps and continuation gaps signal the price moving in different directions, and thus you need to be sure that you have correctly identified the gap before investing.
- Retail investors are usually the ones guilty of showing irrational exuberance. However, institutional investors will sometimes join in to help grow their portfolios, so it is important to take care and be patient before taking a position.
- Lastly, it is essential to watch the stock’s volume, which will indicate what kind of gap it is. Exhaustion gaps have a low trade volume, while breakaway gaps have a high trade volume. After you have correctly identified it, you can attempt to trade.
Is Gap Trading for you?
Gap trading is an advanced investment strategy, and you should only do this if you believe you have the required expertise to read and identify gaps in the price of stocks by studying price charts.
Using technical and fundamental analysis is the required method to identify the type of gap, as correctly identifying the gap is the best way to attain success. How the gap will affect the price and whether the gap will fill depends entirely on the gap category.
Therefore, if you consider playing the gap, you must understand how to identify the gaps and have a solid trading discipline to avoid irrational exuberance.
Gap-fill stocks can give investors healthy returns for savvy traders who correctly identify the gap type. It is important to note that gaps can confirm a trend, signal its reversal, or sometimes do neither. They are just brief inconsistencies on an otherwise mostly stable stock.
As with all investments, gap trading has risks, and returns are not always guaranteed. You can avoid losses by following the real-time electronic communications network that shows real-time trades occurring globally and also by following the trading volume. Never trade if you are in doubt about the viability of the trade.
How Do You Know If a Stock Will Gap Up?
If there are favorable news reports regarding the stock, then there may be multiple overnight trades taking place, and this causes the stock to gap up the following day.
How Do You Predict a Gap Up Opening?
Using the price action method is a good way of predicting whether there will be a gap. If the stock closes on a high on the previous day, there will probably be a gap in the next trading period.
Is Filling a Gap Bullish?
Up gaps are considered bullish. However, filling an up gap is bearish. A down gap is just the opposite, and filling a down gap is bullish.
How Do You Trade Gap and Go?
Search for gaps of 4%. Find the cause of the gap. Mark the premarket highs of the stock and any premarket flags if available. Contact your broker and order to buy the premarket highs before the market opens.
What Causes Stock Gaps?
Gaps occur due to underlying fundamental and technical factors. Such as, if a company's earnings are reported to be higher than expected, the stock price may open on a high the next day, thus leaving a gap.