A gap is a chart pattern that consists of two adjacent bars, where high of previous bar is lower than low of next bar, or low of previous bar is higher than high of next bar.
Gaps occur when prices rise or fall in response to a sudden imbalance of a buy or a sell order. Sudden breakouts of news can often trigger a gap.
There are various kinds of gaps:
- Common Gaps – Common gaps are gaps that close very quickly, usually within a few days and do not repeat regularly. These gaps are often seen in future contracts, thinly traded stocks, etc. Common gaps occur more commonly than other gaps. Common gaps do not provide good trading opportunities, so it is best to avoid them.
- Breakaway Gaps – Breakaway gaps occur when the current price of a stock leaps out of an existing trend and creates a new trend. These gaps can be open for weeks, months, and in some cases, even years. The longer is the range that precedes that gap, the longer is that trend. Breakaway gaps do not close frequently.
- Continuation Gaps – A continuation gap occurs in the middle of a powerful trend, and continues to reach new highs or lows without filling the gap. These gaps can help in estimating how far a trend is likely to carry. Trading strategy for a continuation gap is similar to a breakaway gap.
- Exhaustion Gaps – If a price is not reaching a new high or low for several days after a gap has occurred, it is an exhaustion gap. In an exhaustion gap a new price trend doesn’t occur because prices keep churning and close that gap.
Trading rules for Gaps:
- In a common gap, if the price goes up, sell short as soon as the market reaches a new high and place a protective stop, and vice-versa.
- In a breakaway gap, if prices have gapped to the upside, buy and place a protective stop at the lower rim of the gap. Reverse this procedure in downtrends.
- If a market refuses to reach new highs and lows in the direction of a gap, exit your trade and re – evaluate the market.
- When you identify an upside exhaustion gap, short sell and place a protective stop above the latest high. Reverse this procedure for a downtrend.