Gap Trading

What Is Gap Trading?

Gap trading encompasses strategies that exploit price gaps on a chart. A gap occurs when a security's opening price is significantly higher (gap up) or lower (gap down) than its previous closing price, leaving a visible void on the chart where no trading occurred. Gaps reflect overnight changes in sentiment driven by earnings, news, economic data, or pre-market/after-hours trading activity.

Gaps are most prominent in stock markets, which have defined opening and closing times. Forex and cryptocurrency markets, which trade continuously or nearly so, produce fewer traditional gaps, though weekend gaps in forex are notable exceptions.

Types of Gaps and Their Significance

Breakaway gaps occur at the beginning of new trends, often on very high volume. They gap out of established consolidation patterns and signal that a significant shift in supply/demand has occurred. These gaps tend to remain unfilled for extended periods and should be traded in the direction of the gap.

Runaway gaps appear during established trends and indicate that momentum is accelerating. They often occur at approximately the midpoint of a trend, which is why they are also called measuring gaps (the distance from the trend start to the gap can be projected forward to estimate the trend's end).

Exhaustion gaps occur near the end of a trend, often on climactic volume. They represent the final rush of participants jumping into the trend. When an exhaustion gap is followed by a reversal day (especially an island reversal), it provides a strong counter-trend trading signal.

Gap-Fill Strategies

Fading gaps involves betting that the gap will fill (price will return to the pre-gap close). This strategy works best with common gaps in range-bound stocks. Traders short gap-ups or buy gap-downs, targeting the previous close as their profit objective.

Gap-and-go strategies trade in the direction of the gap, expecting continuation. This approach is suited for breakaway gaps with strong catalysts and high volume. Traders enter on the first pullback after the gap opening, using the gap level as a stop reference point. If price falls back into the gap, the thesis is invalidated.