What Is Gapping?
Gapping occurs when the price of a stock, or other asset, opens above or below the previous day’s close with no trading activity in between. A gap is the area discontinuity in a security's price chart. Gaps may materialize when headlines cause market fundamentals to change rapidly during hours when markets are typically closed; for instance, the result of an earnings call after-hours.
Gapping may also refer to the difference or spread in rates at which banks borrow and lend. The dynamic gap measures how assets (money held) and liabilities (money loaned) change over time.
- A gap occurs when the opening price is far above or below the previous closing price, with no trading activity in between.
- Common gaps tend to be partial gaps, while breakaway, runaway, and exhaustion gaps tend to be full gaps.
- A full gap occurs when the open is fully outside the previous day's price range.
Gapping can occur in any instrument where the trading action closes and then reopens. Stocks do this on a daily basis. Currencies trade continuously throughout the week, but can still experience gaps between when the market closes before the weekend and reopens after.
Gapping may be partial or full in nature. Partial gapping occurs when the opening price is higher or lower than the previous day’s close but within the previous day’s price range. Full gapping occurs when the open is outside of the previous day’s range. Gapping, especially a full gap, shows a strong shift in sentiment occurred overnight.
Types of Gapping
There are different types of gaps, depending on the size of the gap and where they occur within the overall trend of the asset.
- Common gaps occur frequently, have little significance, and are when the opening price is slightly different from the prior closing price. The lack of a significant price move on the gap, or after, shows the gap is common.
- A breakaway gap occurs when the price moves above a significant resistance area or below a significant support area on the gap. It can also occur after the price has been in a tight trading range or when it moves out of a chart pattern. The breakaway gap indicates the start of a strong trending move, is typically a large gap, and the price tends to follow through in the gap direction over the next few weeks.
- Runaway gaps occur during a strong trend and show that the trend is still strong enough to cause a gap in trend direction. In hindsight, these are gaps that occur mid-trend as the trend is really picking up steam. They are typically large and the price tends to follow through, moving in the gap direction over the next few weeks.
- Exhaustion gaps occur near the end of the trend. They are typically caused by stragglers jumping onboard late in a trend after having regret for not getting in earlier. Once the price gaps higher on this last push of demand, there are very few traders left to keep pushing the price in the trending direction. A reversal tends to follow within a few weeks.
Each of these types of gaps can be full or partial gaps. Common gaps are typically partial gaps, as the price doesn't move significantly. However, in some cases, the price may not move much yet still end up being a full gap.
Breakaway, runaway, and exhaustion gaps, meanwhile, tend to be full gaps.
Gapping and Stop Loss Orders
A trader can have a stop-loss order filled significantly below their stop-loss price (for a long position) due to gapping.
For example, a trader may buy a stock on the close at $50 and place a stop-loss order at $45. The next day before the market opens, the company issues an unexpected profit warning, and the stock opens at $38. The trader’s stop-loss order now becomes a market order, because the stock’s price is below $45, and gets filled at the next available price which is the $38 open.
Traders can reduce gapping risk by not trading directly before company earnings and news announcements that are likely to have a material impact on a stock’s price. During periods of high volatility, reducing position size helps to minimize losses caused by gapping.
A trader in a short position can also get caught in a gap, resulting in larger losses than expected. A trader may be short at $20 with a stop loss at $22. The stock closes at $18, in a profitable position for the trader, but overnight another company expresses their interest in buying the company and the price opens up the next day at $25. The trader is punched out of their position at $25, not $22, resulting in an extra $3 per share loss.
Gapping Trading Strategies
Some traders use gaps for analytical insight. For example, if a gap occurs relatively early in a trend, then it is probably a breakaway gap or a runaway gap, which lets the trader know the price likely has further to run.
Other traders use gaps for trading purposes. They may enter positions after a gap occurs.
- Buying the Gap (Up): Day traders often refer to this strategy as the "gap and go." A position could be taken on the day the stock gaps with a stop-loss order usually placed beneath the low of the gap bar. The gap should occur above a significant resistance level and trade on heavy volume to increase the chances of a profitable trade. Alternatively, traders could wait for prices to fill the gap and place a limit order to buy the stock near the previous day's close.
- Selling the Gap (Down): A similar strategy to the one above, except in this case the trader enters a short position following a gap down.
- Fading the Gap: Contrarians may use a fading strategy to exploit gapping. Traders could take a trade in the opposite direction of the gap under the premise that most gaps tend to be filled over time. A stop-loss order is placed above the gap bar’s high, following a gap up, with a profit target set near the previous day’s close. For a gap down, the trader buys, places a stop loss below the gap bar's low, and sets a profit target near the previous day's close.
- Gaps as an Investing Signal: Breakaway and runaway gaps can both signal that there is more trend left to take advantage of. Therefore, following one of these gaps, a longer-term trader may initiate a position in the direction of the gap (typically looking for gaps higher). They may hold onto the trade until an exhaustion gap occurs, or until a trailing stop is hit letting them know to get out.
Gapping Example In the Stock Market
Many stocks have frequent gaps, while others have fewer. Nearly all stocks are susceptible to experiencing a gap following earnings or other major corporate announcements, such as a takeover bid.
A stock may also gap, not because of something the company does, but because the overall market or sector is under selling or buying pressure. If the S&P 500 is sharply lower one morning, many stocks will gap down as a result, for example.
In the chart below, we can see that Facebook Inc. had a number of significantly large price gaps following earnings announcements. It also had many common gaps over the period shown; two are marked on the chart.
The chart also illustrates that a breakaway gap doesn't always need to be in the trending direction. A strong gap against the current trend could signal a break or reversal in the other direction.
The example also shows how devastating a gap can be, even if using a stop loss. Take for example the $217.50 close (high point on the chart). Many people would have bought on that day, as roughly 19 million shares changed hands. The following day the stock opened at $174.89 after a worse than expected earnings announcement. People who bought near $217 lost nearly 20% overnight.