How to Trade Gaps on a Stock Chart
Are all gaps created equal? Nope. There are really only two significant factors to consider when trading gaps. You have to be able to identify if the gap is caused by professional traders or amateur traders. Let's start at the beginning...
What is a gap?
A gap is defined as a price level on a chart where no trading occurred. These can occur in all time frames but, for swing trading, we are mostly concerned with the daily chart.
A gap on a daily chart happens when the stock closes at one price but opens the following day at a different price. Why would this happen? This happens because buy or sell orders are placed before the open that cause the price to open higher or lower than the previous day's close.
Here is an example:
Let's say that on Tuesday, Microsoft closes at $26.57. After the close they come out with their earnings report. They report higher than expect earnings that causes excitement among investors. Buy orders come flooding in. The next day Microsoft opens at $27.60. Since there were no trades between $26.57 and $27.60 this will create a gap on the chart.
Let's look at a chart:
You can see on the chart above that the stock closed at one price and then the next day the stock "gapped up" creating a price void on the chart (yellow circle).
Filling the gap
Sometimes you will hear traders say that a stock is "filling a gap" or they might say that a stock has "a gap to fill".
Are you wondering what the heck they are talking about?
In Japanese Candlestick Charting gaps are referred to as windows. When we say that a stock is "filling a gap", the Japanese would say that the stock is "closing the window".
They are talking about a stock that has traded at the price level of a previous gap. Here is a chart example:
In this example, you can see that the stock gapped down. A few days later it rallied back up and filled in the price level at which there were previously no trades. This is known as filling the gap.
Sometimes you will hear traders saying that "gaps always get filled". This just simply isn't true. Some gaps never get filled, and sometimes it can take years to fill a gap. So I really don't even think it is worth debating because it offer no edge one way or another!
Types of gaps
Traders have labeled gaps depending on where it shows up on a chart. It isn't really necessary to memorize all of these patterns but here is the breakdown so that you can impress your trading friends.
- Breakaway Gaps - This type usually occurs after a consolidation or some other price pattern. A stock will be trading sideways and then all of sudden it will "gap away" from the price pattern.
- Continuation Gaps - Sometimes called runaway gaps or measuring gaps, these occur during a strong advance in price.
- Exhaustion Gaps - This type of gap occurs in the direction of the prevailing trend and represents the final surge of buying or selling interest before a major trend change.
Ok, now we are going to get into the really good stuff...
Professional vs. amateur gaps
When you are looking at gaps on a stock chart, the most important thing that you want to know is this:
Was this gap caused by the amateur traders buying or selling based on emotion?
Was this gap caused by the professional traders that do not make emotional decisions?
To figure this out you have to understand this one important concept first. Professional traders buy after a wave of selling has occurred. They sell after a wave of buying has occurred.
Amateur traders do the exact opposite! They see a stock advancing in price and are afraid that they will miss out on the move, so they pile in - just when the pro's are getting ready to sell.
Here is an example of a gap caused by amateur traders...
See how this stock gapped up after a wave of buying occurred? These amateur traders got emotionally involved in the stock. They piled in after an already extended move to the upside.
These traders eventually lost money as the stock sold off over the next few weeks. Notice how the stock eventually did go back up - but only after a wave of selling occurred (professional buying).
Here is another chart:
See how this stock gapped down after a wave of selling occurred? These amateur traders got emotionally involved in the stock. They sold after an already extended move to the downside.
Ok, so let's break this down, shall we?
- If a stock gaps up after a wave of buying has already occurred, these are amateurs buying the stock - look to short.
- If a stock gaps down after a wave of selling has already occurred, these are amateurs selling the stock - look to go long.
These types of gap plays usually provide great opportunities because they represent and extreme price move.
Well, there you have it...a short primer on trading gaps.
Gaps can provide nice swing trading profits but they can be a little more tricky to trade. The advantage is that you can sometimes make big profits, quickly, and with a little less risk...
...something every trader should strive for.