What is a 'Gap'
A gap is a break between prices on a chart that occurs when the price of a stock makes a sharp move up or down with no trading occurring in between. Gaps can be created by factors such as regular buying or selling pressure, earnings announcements, a change in an analyst's outlook or any other type of news release.
BREAKING DOWN 'Gap'An example of two different gaps can be seen in the chart above. Notice how the stock closes the trading session before the first gap at $50 and opens the next trading day near $46 with no trading occurring between the two prices.
Gaps are a regular occurrence in all financial markets. However, they are rarely seen in the forex market since it is highly liquid and trades 24 hours a day. The open on the first day of the week is where gaps are most likely to occur in the forex market.
Types of Gaps
Gaps most commonly occur at the open of major exchanges. Opening gaps are a manifestation of an imbalance in supply and demand at the market opening in a particular security created during the overnight as a result of a newsworthy event that has an effect on a securities price. Savvy day traders exploit these gaps in an attempt to capture quick profits from the price corrections that take place as sellers and buyers struggle to find a new equilibrium price. Gaps that form in the intraday market are usually a result of an important economic announcement.
Once a gap occurs, it takes one of several forms. A filled gap is one in which the price completely retraces and fills the gap within a few bars subsequent to when the gap took place. Theses gaps typically happen in either direction during sideways range-bound trading markets or in the direction opposite the trend in trending markets. Continuation gaps are normally found in trending markets, and the gaps are typically in the direction of the trend. Price action usually continues in the direction of the trend with strong volume, and the gap is not filled. Breakaway gaps commonly take place when the price breaks out of a trading range or a price pattern.
Trading Strategies for Gaps
Many shrewd traders use gaps as setups for trade entry decisions. A general rule of thumb for trading gaps in the same direction of the minor trend and accompanied by strong volume is to take a position in the direction of the minor trend. For gaps that occur in the opposite direction of the minor trend, traders take a position contrary to the minor trend with a very tight stop-loss. Taking small quick profits with minimal risk is characteristic of gap trading strategies.