Beginner’s Guide to Gap Trading

Tue Nov 24, 2020, 10:09 pm | by Dan Schmidt | No comments

Technical trading patterns can often be hard to spot with the untrained eye.  An experienced trader can spot pennants, wedges, and double tops where a novice might only see a random assortment of candlesticks. Pattern recognition can be an art form, but some trading patterns are obvious and tend to stick out like moths slamming into a porch light. Gaps are one of those obvious patterns. However, just because a pattern is easily identified, doesn’t mean it’s easily traded. Just like any other day trading strategy, gap trading requires technique and practice. Oh, and of course patience too.

What is Gap Trading?

Gap trading is actually a series of strategies and trading techniques based around one particular type of chart pattern: a price gap. Gaps occur when the price of a stock opens above (or below) the previous day’s close by a significant margin. Every stock opens with a different price than it’s previous close, but gap trading involves looking for large empty spaces between the two trading sessions. Gaps are notable because the price action doesn’t occur during normal trading hours.

Like any price movement, a gap moves either up or down and either direction can produce tradable setups. But as is true with many technical patterns, searching for gapping stocks can produce a lot of false positives. Gap traders care about sharp, aggressive price movement here. If a stock opens 1% higher than its previous close, that doesn’t mean it’s ‘gapping up’. A full gap is when the price opens completely above or below the previous day’s range. A partial gap is when the stock opens above or below the previous close, but still within that day’s range.

Why trade gaps? Not only do they make frequent appearances in stock charts, but gaps create opportunities for significant profits due to the volume and volatility that accompanies them. Gaps often materialize due to a catalyst – a bad earnings report, increased guidance, a company scandal, etc. News is often released after hours or in premarket, where experienced traders and investors tend to throw their weight around.  As volatility increases, more traders are drawn to the stock and volume increases. Gap trading can create opportunities for both long and short positions, making it a popular technique amongst bears and bulls.

What Are The Types of Gaps?

Stocks can gap up or gap down, but the direction alone doesn’t tell much of a story. If traders could just blindly buy every stock that jumped 8% in premarket and reap profits, we wouldn’t have much use for charts, would we? To trade gaps successfully, you need to understand what each specific gap means in the broader picture of the stock. Is the gap continuing a trend? Is it breaking a previously held pattern? Or could it just be random market psychology? Knowing the different varieties of gap patterns makes it easier to answer these questions 

Overview of the types of gaps

Breakaway – When a gap bursts through a previously held level of support or resistance, it’s known as a breakaway gap because it usually means the previous trend has been broken. Breakaway gaps often signal the beginning of a new pattern or trend, especially at high volume.

Exhaustion – An exhaustion gap is often the sign of a tired trend. These downward-swinging gaps occur late in the pattern when buyers have begun to fade from the picture. Exhaustion gaps often signal that the uptrend is over and sellers are now in control of the shares.

Common – When there’s no real catalyst or technical reason behind a gap, it’s usually referred to as a common gap. These gaps aren’t going to provide much insight into the stock and they usually get filled quickly.

Continuation – Also known as a runaway gap, continuation gaps occur when a trend is continuing to march in the same direction. Continuation gaps are often the result of sellers (or buyers) capitulating to the trend after waiting around for a reversal that never came.

What is Gap Fill?

A gap fill is when the stock price retraces back through the gap and reaches a previous price point. Gaps don’t always get filled, but retracement occurs with predictable frequency, especially when dealing with common gaps. 

When a gap gets filled, it could be the result of a number of things. Perhaps investors were too bullish or bearish on an initial news event and the stock price moves back down toward its original level as the data settles in. 

How to Trade Gaps

Gap Fading – One popular strategy takes a contrarian view and looks for gaps that are likely to be filled. The common gap and exhaustion gap are the usual suspects found by scanners when searching for fades since the move up (or down) often lacks conviction. When fading a gap, you’ll want to identify a stock that has gapped without much volume or news, usually in early morning trading. Wait for the first candle to confirm your idea and place your entry. You can set an exit point at the previous day’s close or let it ride if the price doesn’t meet resistance.

Gap and Go – The Gap and Go method is a momentum strategy looking to ride the wave of a high gapping stock. Like gap fading, gap and go stocks are found premarket using a scanner or real-time service like Benzinga Pro. Look for stocks making 4-5% moves on high volume. Next, check the float – stocks with few outstanding shares are more likely to continue running higher when the market opens. Locate the best entry point near the premarket high and exit once the shares begin to lose momentum.

Gap Trading Example

When trading gaps, you must confirm the direction of the trend if you want your trades to be successful. A good example from 2020 would be American Airlines (AAL), one of the stocks hit hardest by COVID-19. On November 9th, the stock popped over 20% (from $11.50 to $14.40) at the open, presenting a good opportunity for a gap fade.

The catalyst for the move was the announcement of COVID-19 vaccine data, which is good news for the long-term prospects of the airlines but still a ways off from being implemented. Most stocks across the travel and leisure sectors saw a pop, however, zooming out to the daily chart shows AAL has been in a steady downtrend since July.

A gap fade was a solid trade here as the shares declined rapidly throughout the day. Placing a short in the first 5 minutes of trading gives you an entry price around $14. By 11 AM, the shares were trading below $13 and exiting the trade there would lock in a quick 8% gain. Shares continued to fade throughout the week and the gap was eventually filled on 11/12 when prices dipped back below $11.70.

Final Thoughts

Gap trading requires quick decision making and adherence to a plan, but it remains a consistent system that produces plenty of trading opportunities. A good scanner is advisable when implementing gap trading techniques too since you’ll need to keep an eye on both price movement AND volume to find the best setups. And remember, just because gaps tend to stand out like a Red Sox fan at Yankee Stadium doesn’t mean they’re easy home runs. Reckless gap trading is a quick way to burn a hole through your capital.