Technical Analysis of Gaps: Gap Trading Strategies

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There is an old saying amongst traders that “Gaps are always filled”. You probably know what a gap is. It is when the price on the chart jumps from one level to another, without trading at the values in between. If the gap is filled, that means that the trading price at some future date comes back into the range of prices that was missed. You will most often see gaps on a daily chart, when the opening price on one day is very different from the price that the stock closed at on the previous day. It is much more unusual, for obvious reasons, to see gaps on a weekly or monthly chart.

Gaps can be very awkward. Say you have been keeping a close eye on a security, and have a stop loss in place to protect you from excessive losses. If the price jumps completely over your stop loss with the gap, then you may still face severe losses on your trade. Your broker will implement your stop loss order when the market opens and sell your position at the market price, which may be very different from your stop loss value. There is usually not much you can do about this, although some trading instruments allow you to pay extra and get a guaranteed stop loss.

While you would usually be taken out of your trade by an automatic stop loss, you might want to think that the traders saying could be true, and that if you hung on instead, the price would come back up or down to fill the gap. While in the fullness of time this may well happen, it depends on what type of gap you have whether this is likely.

You see there are three types of gap. The breakaway gap will show up at the end of a price pattern, and usually comes in the new direction as a strong indication of the reversal. This will have heavy trading volume, and it is unlikely to be filled anytime soon.

The second type of gap is the runaway gap, which is sometimes called a measuring gap. You can see this one in a strong trend, when it often occurs around the middle of the trend move, which is why it may be called a measuring gap, indicating the half way position. Once again, this type of gap will often not be filled in a reasonable time, as the market is taking the price further away.

With either of these gap types, you should note the price levels of the gap. If sometime in the future there is a retracement of the market to this price range, then the price levels may form support or resistance levels.

The third type of gap is called the exhaustion gap, and this one is very likely to be filled quickly. It usually occurs at the end of a trend, and is a sort of last gasp of the market jumping in the trend direction just before the trend fails. As such, the price will soon cover the missing values.


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