Gaps are areas on a chart where the price of a stock (or another financial instrument) moves sharply up or down, with little or no trading in between. As a result, the asset's chart shows a "gap" in the normal price pattern. The enterprising trader can interpret and exploit these gaps for profit. This article will help you understand how and why gaps occur, and how you can use them to make profitable trades.

Gap Basics
Gaps occur because of underlying fundamental or technical factors. For example, if a company's earnings are much higher than expected, the company's stock may gap up the next day. This means that the stock price opened higher than it closed the day before, thereby leaving a gap. In the forex market, it is not uncommon for a report to generate so much buzz that it widens the bid and ask spread to a point where a significant gap can be seen. Similarly, a stock breaking a new high in the current session may open higher in the next session, thus gapping up for technical reasons.

Gaps can be classified into four groups:

  • Breakaway gaps are those that occur at the end of a price pattern and signal the beginning of a new trend.
  • Exhaustion gaps occur near the end of a price pattern and signal a final attempt to hit new highs or lows.
  • Common gaps are those that cannot be placed in a price pattern - they simply represent an area where the price has "gapped."
  • Continuation gaps occur in the middle of a price pattern and signal a rush of buyers or sellers who share a common belief in the underlying stock's future direction.

To Fill or Not to Fill
When someone says that a gap has been "filled," that means that the price has moved back to the original pre-gap level. These fills are quite common and occur because of the following:

  • Irrational Exuberance: The initial spike may have been overly optimistic or pessimistic, therefore inviting a correction.
  • Technical Resistance: When a price moves up or down sharply, it doesn't leave behind any support or resistance.
  • Price Pattern: Price patterns are used to classify gaps, and can tell you if a gap will be filled or not. Exhaustion gaps are typically the most likely to be filled because they signal the end of a price trend, while continuation and breakaway gaps are significantly less likely to be filled, since they are used to confirm the direction of the current trend.

When gaps are filled within the same trading day on which they occur, this is referred to as fading. For example, let's say a company announces great earnings per share for this quarter, and it gaps up at open (meaning it opened significantly higher than its previous close). Now let's say that, as the day progresses, people realize that the cash flow statement shows some weaknesses, so they start selling. Eventually, the price hits yesterday's close, and the gap is filled. Many day traders use this strategy during earnings season or at other times when irrational exuberance is at a high.

SEE: The Madness Of Crowds

How to Play the Gaps
There are many ways to take advantage of these gaps, with a few more popular strategies. Some traders will buy when fundamental or technical factors favor a gap on the next trading day. For example, they'll buy a stock after-hours when a positive earnings report is released, hoping for a gap up on the following trading day. Traders might also buy or sell into highly liquid or illiquid positions at the beginning of a price movement, hoping for a good fill and a continued trend. For example, they may buy a currency when it is gapping up very quickly on low liquidity and there is no significant resistance overhead.

Some traders will fade gaps in the opposite direction once a high or low point has been determined (often through other forms of technical analysis). For example, if a stock gaps up on some speculative report, experienced traders may fade the gap by shorting the stock. Lastly, traders might buy when the price level reaches the prior support after the gap has been filled. An example of this strategy is outlined below.

Here are the key things you will want to remember when trading gaps:

  • Once a stock has started to fill the gap, it will rarely stop, because there is often no immediate support or resistance.
  • Exhaustion gaps and continuation gaps predict the price moving in two different directions - be sure that you correctly classify the gap you are going to play.
  • Retail investors are the ones who usually exhibit irrational exuberance; however, institutional investors may play along to help their portfolios - so be careful when using this indicator, and make sure to wait for the price to start to break before taking a position.
  • Be sure to watch the volume. High volume should be present in breakaway gaps, while low volume should occur in exhaustion gaps.

To tie these ideas together, let's look at a basic gap trading system developed for the forex market. This system uses gaps in order to predict retracements to a prior price. Here are the rules:

1. The trade must always be in the overall direction of the price (check hourly charts).
2. The currency must gap significantly above or below a key resistance level on the 30-minute charts.
3. The price must retrace to the original resistance level. This will indicate that the gap has been filled, and the price has returned to prior resistance turned support.
4. There must be a candle signifying a continuation of the price in the direction of the gap. This will help ensure that the support will remain intact.

Note that because the forex market is a 24-hour market (it is open 24 hours a day from 5pm EST on Sunday until 4pm EST Friday), gaps in the forex market appear on a chart as large candles. These large candles often occur because of the release of a report that causes sharp price movements with little to no liquidity. In the forex market, the only visible gaps that occur on a chart happen when the market opens after the weekend.

Let's look at an example of this system in action:

Figure 1 - The large candlestick identified by the left arrow on this GBP/USD chart is an example of a gap found in the forex market. This does not look like a regular gap, but the lack of liquidity between the prices makes it so. Notice how these levels act as strong levels of support and resistance.

We can see in Figure 1 that the price gapped up above some consolidation resistance, retraced and filled the gap, and finally, resumed its way up before heading back down. We can see that there is little support below the gap, until the prior support (where we buy). A trader could also short the currency on the way down to this point, if he or she were able to identify a top.

The Bottom Line
Those who study the underlying factors behind a gap and correctly identify its type, can often trade with a high probability of success. However, there is always a risk that a trade can go bad. You can avoid this, firstly, by watching the real-time electronic communication network (ECN) and volume. This will give you an idea of where different open trades stand. If you see high-volume resistance preventing a gap from being filled, then double check the premise of your trade and consider not trading it if you are not completely certain that it is correct.

Second, be sure that the rally is over. Irrational exuberance is not necessarily immediately corrected by the market. Sometimes stocks can rise for years at extremely high valuations and trade high on rumors, without a correction. Be sure to wait for declining and negative volume before taking a position.Lastly, always be sure to use a stop-loss when trading. It is best to place the stop-loss point below key support levels, or at a set percentage, such as -8%.

Remember, gaps are risky (due to low liquidity and high volatility), but if properly traded, they offer opportunities for quick profits.