Before getting to the gap and going trading strategy, we need to understand what exactly is a gap. A gap in trading is something that happens mostly on daily charts because they don’t reveal price actions at pre-market and post-market hours. A gap is space due to lack of trading activity on a stock chart.
When a stock asset makes a big move up during extended hours, it is called “gap up”, and when a stock makes a huge move down during extended market hours, it is called “gap down”.
Most traders refrain from trading gaps because they think that the stock has already made a move during the extended hours and trading it after will make no sense. But that is not a real scenario.
Even after the move has been made, gaps offer best day trading opportunities because they come with a rise in volatility as well as volume.
One must understand the whims and fancies of trading gaps thoroughly. There are a variety of ways to trade gaps, in both long and short terms. Each of the forms will require a different methodology to be followed.
Types of gaps
The trading gaps can be classified into four groups:
- Exhaustion gaps take place near the end of a price pattern and signal final high or low of the price.
- Breakaway gaps take place at the end of a price pattern and point out a new or fresh trend.
- Continuation gaps are also called runaway gaps and occur in the middle of a price pattern and depict a set of buyers and sellers interested in the direction of the stock or asset.
- Common gaps represent an area where the price has gapped.
How to trade gaps?
The first step would be to identify gaps. Look out for news headlines, and other information to find gaps. After you have found the largest gaps, the next step is to find out which ones will gap and go. This part of the strategy is very crucial because most stock gaps go up and come back straight down.
Strategies and criteria to know what gaps will go up:
- Look out for a powerful catalyst. A catalyst is any piece of information released by the company, which can be the cause for a gap. The strength of the catalyst determines whether a stock will gap and go or not. However, there is no particular way of selecting and identifying a strong catalyst.
- A large amount of added supply to the market is called dilution, and it can be one of the major drawbacks for any company. All of that extra supply of the company will reduce the stock price, and it will be difficult for the stock to gap and go.
- Please take a look at the long term (1-3 years) charts of the stock and see how the stock has performed every time it has gapped up in the market. A stock that has been in a downtrend and goes down after a gap up is not likely to gap and go, whereas, a stock that is in an uptrend and has raised into gains in the past is likely to gap and go.
- Little or significantly less resistance makes a stock likely to gap and go. Resistance levels are prices where stock struggles due to more supply than demand. Such prices could get in the way of stock to gap and go.
- Correctly classify the gap you want to move along. Exhaustion gaps and continuation gaps predict different price directions.
- Be sure to keep a check on volume. High volumes are to be present in breakaway gaps, while low volume might occur in exhaustion gaps.
When a gap is filled, it means the price has gone back to the original, pre-gap level. These gap fills are very common and can happen because of the following reasons:
- Sometimes the initial spike can be irrational and can be very optimistic or pessimistic, and therefore requires rectification.
- When price changes and goes high or low very sharply, it offers no resistance or support.
- Price patterns are constructive in determining if the gap will get filled or not. Exhaustion gaps are likely to be filled because they point towards the end of a price trend, while the continuation and breakaway gaps are not likely to get filled as they confirm the current trend.
When the gaps are, thus, filled within the same trading day, it is known as fading.
Pros and cons of the gap and go trading strategy:
Every trading strategy has its plus and minus points, and gap and goes no exception.
Gap and go is an ideal strategy for stocks and indices. Gaps are more common to occur in these markets as they open and close at fixed hours.
You cannot apply a gap and go strategy to forex markets as the markets are open 24/7. The gap can only occur on weekends when the market is closed. Also the brokerage firms of the forex market are also reliable and well-regulated, like InvestFW
The gap and go strategy can be risky at times. It would be best if you had a good and efficient broker who can give you reasonable prices. And one needs to take spreads precisely into account while using gap and go strategy.