What is a 'Gap'

Gap, when it comes to investing, is a break between prices on a stock chart that occurs when the price of a stock makes a sharp move up or down with no trading occurring in between.

BREAKING DOWN 'Gap'

Gaps can be created by factors such as regular buying or selling pressure, earnings announcements, a change in an analyst's outlook or a news release. They 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 when gaps are most likely to occur in the foreign exchange market.

In general, gaps occur at the open of major exchanges. Opening gaps result from a newsworthy event that happens after trading is over, which has an effect on the price of a security. This effect outside of trading hours results in an imbalance in supply and demand when the market opens the next day, thus leading to a gap.

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 major economic announcements.

Types of Gaps

Once a gap occurs, it can take one of several forms:

A filled gap is one in which the price completely retraces and fills the gap within a few bars following the gap. These gaps typically happen in either direction during sideways range-bound trading markets or in the direction opposite the trend in trending markets.

Another type of gap is a continuation gap, which is normally found in trending markets. These gaps typically follow in the direction of the overall trend, upwards in a rising trend and downward in a declining trend. Since the price action following the gap usually continues in the direction of the trend, the price never retraces, or fills, the gap.

Breakaway gaps commonly take place when the price breaks out of a trading range or a price pattern.

Many traders use gaps as a way to set up their decisions about when to enter a trade. A general rule of thumb that many traders use for trading continuation gaps amid 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.

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