Trading Gaps: Strategies and Techniques for Profitable Entry and Exit Points

Trading gaps refer to a particular phenomenon whereby a significant difference occurs between a financial instrument’s opening price and the closing price of the previous day. Traders aim to capitalize on these price discrepancies because they accompany enticing trading opportunities.

If you wanted to learn all about gaps trading, then you are on the right platform. Because in this article, we are going to help you to learn the fundamentals of these gaps and identify different types of gaps. Additionally, we are also going to explain some effective gap trading strategies for entering and exiting trades with high-profit potential.

What are trading gaps?

Whenever supply and demand misbalance occurs or market sentiment shifts, trading gaps appear. These are the gaps that appear on trading charts when the price action takes a sudden jump. In simple terms, trading gaps refer to gaps occurring because of the opening price of a financial instrument at a significantly higher or lower level than the previous day’s closing price. 

Gaps also accompany lucrative trading opportunities. Traders use gap analysis to hunt those trading opportunities. However, it is important to learn the fundamentals of these gaps and relevant trading strategies to trade them. Moreover, there are three types of gaps that occur because of the opening and the previous day’s closing price of a security.

1. Common gaps

Common gaps refer to gaps occurring because of normal price fluctuations. They appear frequently on price charts and don’t last for long.

2. Breakaway gaps

Breakaway gaps, as the name suggests, appear at the start of a new trend in the market. This type of gap indicates a shifting market sentiment and last for a long time.

3. Exhaustion gaps

Exhaustion gaps are the inverse of breakaway gaps because they occur near the end of a trend. They indicate an imminent trend reversal and also stay for a long time.

Fundamentals of trading gaps

As stated above, trading gaps refer to a financial asset’s opening price and the previous day’s closing price discrepancies. Here are the fundamentals of gaps you need to understand well to capitalize on the trading opportunities they accompany.

1. What causes trading gaps?

Gaps occur because of noticeable events happening such as earning reports, major economic announcements, news releases, or any other major market events. 

2. Volume

Volume is a very important metric that you need to consider in gaps trading. It gives you an indication of the likelihood of continuation or reversal of a trend. For instance, high volume during a gap indicates heavy buying or selling pressure. Therefore, you can consider it an indication of the continuation of the gap.

3. Trend

Considering overall market trends is also crucial when you seek to trade these price differences. This is because if the gap occurs in the direction of a trend, it indicates trend continuation. Conversely, if the gap occurs in the opposite direction, it indicates a potential trend reversal.

4. Areas of support and resistance

Support and resistance areas are also important when trading these gaps just like they are crucial when trading other strategies. The trend may likely continue if the gap occurs at a key support or resistance area.

5. Gap fill

Gap fill is a scenario that refers to the filling up of a gap. That means the price returns to the normal level as it was before the gap’s appearance. This is a metric that enables traders set stop-loss and take profit targets.

Strategies to trade trading gaps

As we have mentioned earlier, gaps accompany lucrative trading opportunities. However, it is important to effectively use these gaps to your advantage. You need to understand that trading gaps are also risky. Therefore, always proceed with caution. The following are some effective gap trading strategies that you can employ for maximum gains.

1. Momentum trading strategy

Momentum’s trading strategy is a trade with the trend strategy. It involves capitalizing on the momentum that gaps generate. The strategy requires traders to buy when the gap is up expecting the trend will continue and the price will increase. Contrarily, it requires traders to sell when the gap is down hoping the trend will continue and the price will decline.

2. Reversal trading strategy

The reversal trading strategy is a contrarian trading approach. It involves trading against the gap. That means it requires traders to sell when the gap is up. It relies on the expectation that the trend reversal is imminent and the price will move lower. Contrarily, it requires traders to buy when the gap is down hoping that the trend reversal is near and the price will move higher.

3. Gap-fill strategy

Gap-fill strategy aims to capitalize on gaps that are most likely to get filled. It depends on the likelihood of the price moving back to the previous day’s closing price. Therefore, the strategy requires traders to buy when the gap is down and vice versa.

4. Gap and Go strategy

Gap and Go strategy involves acting immediately after the occurrence of a gap. It aims to capitalize on the initial move happening after the gap appearance. The strategy requires traders to enter a trade with the expectation that the trend will continue in the anticipated direction.

Tips to trade trading gaps

Gaps trading is risky. Therefore, follow the following gaps trading tips to maximize the odds of your success.

• There are three types of gaps as discussed earlier. You need to correctly identify the type of gap because each type indicates a different signal.
• It is always important to enter a trade after confirmation. That means you need to wait for the trend to develop in the expected direction.
• Use technical analysis to identify and confirm a trend before entering a trade.
• Always use stop-loss orders to cut your losses short in case of trade going against you.
• Set realistic take profit targets and realize a profit at the right time.
• Always monitor the overall market and keep an eye on the broader market sentiment. It empowers you to make informed gaps trading decisions.

The wrap-up

Trading gaps are a phenomenon in financial markets that accompanies lucrative trading opportunities. There are a few effective trading strategies to trade these gaps. However, it is also important to understand that trading gaps are risky. You may experience significant price movements when trading gaps that cause huge losses. Therefore, it is important to thoroughly understand the market and use risk management techniques before embarking on the road to trading gaps.