Gap Types: Definition and Trading Strategy (Backtest)

Gap types in trading refer to the patterns formed when there is a significant difference between the closing price of one trading session and the opening price of the next. These gaps can provide valuable insights into market sentiment and potential trading opportunities.

When a stock price leaps or plummets leaving a space on the chart, that’s a stock gap. These stock gaps are more than just chart features; they are vital indicators of market sentiment and potential trend shifts. The comprehensive walkthrough that follows explains what triggers these stock gaps and how they can influence your trading decisions.

In this article, we’ll give you statistics, numbers, data, performance metrics, and facts, which we did by backtesting. Hopefully, you will get more knowledge than from other websites’ traditional anecdotal and boring descriptions.

Key Takeaways

• Stock gaps signify areas where no trading has occurred, often indicating the start or end of a trend, influenced by market events and news.
• Not all gaps are filled; their likelihood to close depends on type—common gaps fill quickly whereas breakaway gaps may not, influencing trading strategies.
• Various gap types—common, breakaway, runaway, and exhaustion—offer different trading signals and require different strategies, like Gap and Go or Gap Fading.
• We provide historical evidence, statistics, data-driven numbers, facts, and performance via backtesting.

What are some different types of gaps?

Some different types of gaps include breakaway, runaway (measuring), exhaustion, and common gaps.

Each gap type provides traders with a distinct signal, aiding in predicting potential future price movements.

Exhaustion Gap

An exhaustion gap typically occurs after a rapid rise or fall in a stock’s price and signals a significant change in the demand for the stock. It suggests that the market’s buyers are exhausted, implying that the trend may stop as sellers begin to take profits. High trading volume is often associated with exhaustion gaps, and they are typically filled more often as they indicate the end of a price trend.

This type of gap is particularly noteworthy because it represents a climax or culmination of a trend, where the forces of supply and demand reach a tipping point. An exhaustion gap often appears after a prolonged or steep trend, where the price action has been consistently in one direction.

The gap itself is a product of the final surge of enthusiastic buying or selling, which pushes the price to an extreme level. It’s like the last gasp of a fireworks display—the brightest and loudest burst before the show ends.

Traders keep a keen eye on exhaustion gaps as they can present a significant turning point in the market. The gap is often accompanied by a noticeable increase in volume, which can confirm that many traders have participated in the move. This increased activity is a double-edged sword; it may indicate a strong consensus about the current price direction, but it also means that the prevailing trend may be overextended and ready to reverse.

Once an exhaustion gap is identified, traders often watch for signs of a reversal. If the gap begins to fill, it can reinforce the idea that the trend is losing momentum and that the market is transitioning into a new phase.

This can lead to various trading strategies, including taking profits from existing positions or preparing for a potential reversal trade. The key to effectively trading exhaustion gaps is to recognize the signs early and to act decisively, using the gap as a signal for the end of the current trend and the beginning of a possible new one.

Runaway Gap

Runaway gaps, also known as continuation gaps, occur during a strong trend and signal that the trend is likely to continue. Unlike exhaustion gaps, runaway gaps are not typically filled quickly as they reinforce the current market direction. Strong trends drive this type of gap, sometimes referred to as a measuring gap, indicating that a current trend is likely to proceed.

These gaps can be particularly exciting for traders who have already positioned themselves in the direction of the trend, as they can be seen as a confirmation of their trading thesis. Runaway gaps often occur with increased volume, which can further validate the strength of the trend and the gap itself.

For traders not yet in the market, these gaps can represent a potential opportunity to join the trend with the expectation of continued momentum. However, it’s important to approach these gaps cautiously, as entering a trade after a gap can carry the risk of chasing the price.

Breakaway Gap

Breakaway gaps occur when a stock’s price moves out of a trading range or consolidation pattern, indicating the start of a new trend. Higher trading volume often accompanies these gaps, which can add credibility to the signal that a new trend is beginning. They often do not fill quickly, representing a structural market change such as breaking through a key resistance or support level.

This type of gap is particularly important for technical analysts and traders, as it can clearly indicate a potential shift in market dynamics. Moreover, market participants closely monitor breakaway gaps because they can offer profitable opportunities for trend-following strategies or for those looking to capitalize on the momentum generated by the shift. While it might be tempting to jump into a position following a breakaway gap, traders must conduct statistical analysis to confirm that the gap isn’t a false signal and to implement sound risk management practices to protect against potential losses.

Common Gap

Common gaps are small gaps in price that occur frequently in the stock market and are often caused by routine trading activity. They tend to be filled quickly, sometimes within a few hours or days, making them less significant for long-term trading strategies.

Common gaps do not typically indicate any significant change in market sentiment or trend direction, and they are more likely to appear in illiquid stocks or during times when the market is not reacting to any major news or events.

An example of a common gap is the trading in GLD, the ETF that tracks the gold price. Because gold is traded 24 hours a day, while GLD only trades during change hours, we get a lot of gaps, in which most don’t signal anything:

Clearly, the chart has a lot of “holes” of gaps.

Despite their routine nature, common gaps can still offer short-term trading opportunities for those who are vigilant. Day traders, in particular, may exploit these gaps for quick profits, provided they have the right tools to identify and act on them promptly.

Furthermore, common gaps can serve as a reminder to traders that not all price movements are indicative of a market-wide shift. This reinforces the importance of context when analyzing gaps; understanding whether a gap is common or of another type can greatly influence a trader’s decision-making process.

What does a gap mean in technical analysis?

A gap in technical analysis is a space on the stock chart where no trading activity has occurred. Such gaps are often driven by significant market events or news, pushing a substantial number of buyers or sellers to participate in trading.

Consequently, the price at market open can be dramatically higher or lower than the previous day’s closing price. Such abrupt price fluctuations may hint at the inception of a fresh trend or the reversal of a current one, contingent on the nature of the gap.

There are four main types of gaps:

1. Common gaps, which occur frequently, tend to fill quickly and don’t require a major event.
2. Breakaway gaps may indicate a continuation or the start of a trend.
3. Runaway gaps may also indicate a continuation or the start of a trend.
4. Exhaustion gaps may signal the end of a trend.

Each type of gap offers different signals to traders.

Are all gaps filled?

All gaps are not filled, but the great majority are, according to backtests and statistics. We have written about the fill rate of gaps in a previous article.

Although it might appear that all gaps will eventually close, that is not necessarily the case. Several factors, including the cause of the gap and the surrounding trading activity, influence whether a gap will close. For example, breakaway gaps, which signal a new trend and emerge at the end of a price pattern, often remain unfilled or may only partially fill.

It also depends on which asset you are looking at. A stock market index is more probe to fil the gap than a commodity, or at least it takes more time.

On the other hand, common gaps, which occur regularly and do not signify any significant market shift, often get filled relatively quickly. Therefore, understanding the type of gap and the market dynamics around it is crucial in predicting whether or not it will be filled.

How often do stocks fill gaps?

Often stocks fill gaps – the great majority is filled.

However, not all gaps are filled. The rate at which gaps in stocks fill can significantly vary, depending on individual security and prevailing market conditions.

Nevertheless, market studies indicate that stock gaps tend to close more frequently than commonly believed. For instance, for the QQQ Nasdaq ETF, gaps down filled on the same day at rates of 77% for gaps between 0.5% and 0.99%, while gaps up filled on the same day at rates of 72% for the same range. However, when given two days to fill, the rates increase. In other words, almost all gaps are filled.

It’s also worth noting that down gaps have a higher fill rate compared to gap ups on the same day.

What percentage of stock gaps get filled?

The percentage of stock gaps that get filled is approximately 70-80%. Although no fixed percentage of stock gaps get filled, it is observed that the majority of gaps eventually close over a certain period.

For instance, for down gaps in the QQQ ETF ranging from 0.5% to 0.99%, 77% were fully closed on the same day, increasing to 84% within two days. For up gaps in the same range, 72% were fully closed on the same day, increasing to 79% within two days.

These fill rates suggest a strong likelihood of gaps closing within a short time frame, although it’s not a guaranteed occurrence.

What causes gaps?

Gaps in trading are caused by sudden shifts in supply and demand, often triggered by unexpected news, events, or market sentiment. A variety of factors can contribute to gaps in stock prices.

A gap typically arises when a considerable number of buyers or sellers enter the market in response to news or events, leading to a discontinuity in the price chart. For instance, a gap might be caused by an earnings report that exceeds expectations, a change in a company’s outlook, or a broader market event.

Algorithmic trading, characterized by large automated trades, can also trigger gaps in the price chart. Regardless of the cause, a gap can provide valuable insights into market dynamics and sentiment.

What is the psychology behind gaps?

The psychology behind gaps in trading often involves a combination of fear of missing out (FOMO) and fear of loss (FOL). Traders may interpret gaps as significant shifts in market sentiment or new information, leading to impulsive actions driven by emotions rather than rational analysis. Additionally, gaps can create psychological pressure to act quickly to capitalize on perceived opportunities or to mitigate potential losses, amplifying market volatility.

The psychological dynamics behind gaps stem from abrupt shifts in market sentiment. For example, the release of a positive earnings report after trading hours could lead to a gap up, as it changes investor expectations and results in a higher opening price the next day.

Conversely, a gap down may signal a potential transition from an upward trend to a downward trend, suggesting that sellers are beginning to take profits.

Various psychological phenomena, such as irrational exuberance, herd mentality, and loss aversion can also influence the formation of gaps. Understanding the psychological factors influencing gap formation is key to successful gap trading.

Gaps trading strategies

Traders have several strategies at their disposal to take advantage of price gaps. One popular strategy is the Gap and Go, which involves identifying stocks with significant price gaps and trading them when the market opens. Another strategy is Gap Fading, which involves trading against a gap with the expectation that the price will reverse and ‘fill’ the gap.

For an example of a gap trading strategy, please look at the quantified trading rules for an exhaustion gap trading strategy.

Traders might also employ a gap-fill strategy, which involves entering a trade after a gap has been filled, betting on continuing the trend, or a potential reversal. Each strategy has its own set of risks and rewards, and traders need to understand the underlying dynamics of each before implementing them in their trading approach.

What does an up gap mean?

A “Up Gap” refers to a price gap where the current trading price is higher than the previous session’s high. An up gap occurs when a security’s opening price is considerably higher than its previous closing price, resulting in a ‘gap’ on the chart.

This typically occurs when the stock has positive news, such as better-than-expected earnings reports or other favorable company-specific or economic data. An up gap can often indicate bullish market sentiment and may reflect increased investor interest and buying pressure.

Depending on the type of gap and accompanying trading volume, an up gap can signal either the start of a new trend or a continuation of an existing upward trend.

What does a down gap indicate?

A Down Gap in trading typically indicates a sharp decline in price where the current day’s low is higher than the previous day’s high, suggesting increased selling pressure and potential bearish momentum.

A down gap is a scenario where a security’s opening price is significantly lower than the previous day’s closing price. This can often be a reaction to negative news, such as an earnings miss or adverse macroeconomic data. A down gap can act as a resistance level for the stock, as the price may struggle to move above the gap. It may also signal a potential reversal if it occurs at the end of an uptrend, indicating that selling pressure is overwhelming buying interest.

Volume is a crucial indicator when interpreting a down gap, as high volume suggests stronger bearish sentiment, while low volume may suggest less conviction among sellers.

What are the risks with gaps?

The risks with gaps in trading include increased volatility, potential for significant price movement, and difficulty in executing trades at desired prices.

Similar to any trading strategy, trading gaps involve its own set of risks. One key risk with gaps is that they can provide false signals. For instance, a gap may suggest the start of a new trend, but if it quickly fills, it may have been just a temporary overreaction to news.

Another risk is liquidity. Gaps can cause liquidity issues, making it difficult for traders to enter or exit positions at their desired price levels. This is particularly true in less liquid markets, where gaps are more frequent and larger due to the increased likelihood of slipping prices.

Traders also risk misjudging the type of gap, which can lead to incorrect trading decisions. For instance, an exhaustion gap that is mistaken for a breakaway gap could result in a trader holding onto a position expecting a new trend, only to see the price reverse and the gap fill.

Why do stocks gap overnight?

Stocks gap overnight due to significant changes in market sentiment or new information that occurs when the stock market is closed. Several factors can cause stocks to gap overnight. News events that occur while the markets are closed, such as earnings reports or major company announcements, can lead to significant changes in the stock’s perceived value, causing it to open the next trading day at a different price level.

Also, changes in investor sentiment based on after-hours news can lead to a gap in stock prices the next morning. Algorithmic trading, characterized by large automated trades, can also trigger gaps in the price chart when a technical level is broken.

What is a fair value gap?

In trading, a fair value gap refers to the perceived difference between the current market price of an asset and its intrinsic or fair value.

A fair value gap occurs when a stock’s price significantly diverges from its perceived fair value. This often occurs within a three-candle sequence on a chart and is visualized as a large candle whose neighboring candles’ wicks do not fully overlap the large candle, creating a space known as the fair value gap. Such a gap becomes a magnet for price in the future, as the imbalance can draw the price back to the gap area.

Once a fair value gap is filled, the price can continue in its previous direction because the imbalance that created the gap has been resolved.

How do you trade fair value gaps?

To trade fair value gaps, you need to monitor discrepancies between the current market price and the intrinsic value of an asset. Buy when the market price is below fair value and sell when it’s above. Use fundamental analysis to assess fair value.

Trading fair value gaps entails identifying stocks with substantial price deviations from their fair value and expecting a reversion to the fair value. For instance, if a stock has gapped up significantly beyond its fair value, a trader might short sell the stock with the expectation that the price will return to its fair value, effectively ‘filling’ the gap.

Similarly, if a stock has gapped down significantly below its fair value, a trader might buy the stock with the expectation that the price will return to its fair value.

Risk management is crucial when trading fair value gaps, as the price may not always revert to the fair value, and traders should be prepared for potential losses.

When we day traded full time from 2001 until 2018, we were active fair value gaps traders. We have covered our results in an article called is it possible to make money day trading.

Are gaps common in stocks?

Yes, gaps are common in stocks. Gaps are undoubtedly a frequent occurrence in the stock market. Their frequency, however, can vary depending on factors such as the liquidity of the market and the timeframe being observed. Common gaps occur regularly and do not necessarily represent a significant change in market sentiment. They are often filled quickly, sometimes even within the same trading day.

On the other hand, gaps such as breakaway or runaway gaps, which signify the start or continuation of a trend, are less frequent but can have more significant implications for traders.

How do you predict a gap up opening?

To predict a gap up opening in trading, analyze pre-market activity, news, earnings reports, and overall market sentiment for indications of positive momentum that could lead to higher opening prices. You find this by looking at where the futures are trading, and even where the ETF is trading.

Forecasting a gap opening necessitates evaluating various factors that could propel the stock’s price upwards. Some factors to consider include:

• News events, such as a positive earnings report or a favorable announcement from the company
• Technical indicators, such as a stock breaking a new high
• Observing large algorithmic buy orders that could trigger a price gap, particularly if a prior high is broken

By considering these factors, you can make a more informed prediction about a potential gap up opening.

However, it’s important to note that predicting gaps is not an exact science, and traders should always consider other market factors and use effective risk management strategies.

What happens after the gap is filled?

After the gap is filled in trading, various scenarios can emerge. The stock’s price can continue to move in the same direction as the original gap, suggesting the continuation of the previous trend. Alternatively, the price may reverse direction, potentially indicating a trend reversal or a shift in market sentiment. The subsequent price movement can depend on various factors, such as the type of gap, market conditions, and investor sentiment.

For instance, if an exhaustion gap (which typically signals the end of a trend) is filled and the price continues in the direction of the gap, it may suggest that the gap was part of a sustainable price move.

Does gap affect stock prices?

Yes, gap affects stock prices in various ways. Gaps can have a significant impact on stock prices. They often occur when market fundamentals change during off-hours due to events like earnings calls, leading to a different opening price the next trading day.

A gap can signal the start of a new trend, a reversal of an existing trend, or a strong shift in market sentiment, all of which can influence stock prices. Gaps can also create new areas of support or resistance, which can affect future price movements.

For instance, a gap up may create a new resistance level if the price struggles to move above the gap, while a gap down may form a new support level if the price fails to fall below it.

How to trade gap chart pattern?

To trade the Gap Chart Pattern, look for significant price gaps between consecutive trading sessions. Buy when the price fills the gap (gap up) or sell short when the price falls into the gap (gap down). Use stop-loss orders to manage risk and consider confirming signals from other indicators or patterns.

Trading gap chart patterns necessitates a deep understanding of the various gaps and their ramifications. One popular strategy is the Gap and Go, which involves identifying stocks with significant price gaps and trading them at the market open. Another strategy is Gap Fading, which involves trading against a gap with the expectation that the price will reverse and ‘fill’ the gap.

Traders might also employ a gap-fill strategy, which involves entering a trade after a gap has been filled, betting on continuing the trend or a potential reversal. These strategies require careful analysis of the gap’s context, such as news events or significant trading volume.

How do you identify gaps in trading?

Identifying gaps in trading involves scrutinizing price charts for abrupt jumps or spaces between trading periods, indicating significant shifts in supply and demand dynamics.

The identification of gaps in trading necessitates a careful examination of stock charts for regions where no trading has taken place, resulting in a blank space or a ‘gap’ on the chart. Gaps typically occur when there’s a significant shift in the number of buyers or sellers in the market, causing a sharp price movement with no trading in between.

Traders can manually spot gaps by looking for these spaces in the price chart. Alternatively, they can use charting tools or software automatically highlighting gaps, making it easier to spot potential trading opportunities.

What are some examples of gaps in trading?

Examples of trading gaps include price, volume, and breakaway gaps. Let’s look at a few examples to elucidate the concept of gaps in trading.

A breakaway gap occurred with Amazon.com Inc. (AMZN) between Oct. 26, 2023, and Oct. 27, 2023, where the price jumped from $119.57 to $127.74, reversing a downward trend and continuing to climb (see red rectangle).

In contrast, Alphabet Inc. (GOOGL) experienced a gap that was eventually filled, between Oct. 24, 2023, and Oct. On June 25, 2023, the price fell from $138.81 to $125.61 following several weeks of increase.

Can gaps be used to identify support and resistance levels?

Yes, gaps can be used to identify support and resistance levels in trading. For instance, an up gap can create a new resistance level if the price struggles to move above the gap, while a down gap can form a new support level if the price fails to fall below the gap.

In other words, once a gap is formed, the price level at the top or bottom of the gap can serve as a potential area of resistance or support, respectively. This is because gaps represent areas where no trading has occurred, and as such, they can influence future price movements as prices tend to reverse upon reaching these gap levels.

Are gaps reliable trading signals in technical analysis?

While gaps can be considered trading signals in technical analysis, their reliability varies depending on market conditions and context.

When interpreted and bactested correctly and used alongside other indicators, gaps in technical analysis can yield reliable trading signals.

For instance, a gap up or down can indicate a new trend’s start or a current trend’s reversal, providing a potential trading signal. However, not all gaps are created equal, and their reliability can vary depending on factors such as the type of gap, the market conditions, and the trading volume. Also, the significance of a gap varies from asset to asset.

For instance, high volume is often associated with breakaway gaps, suggesting a significant change in market sentiment and a potentially reliable trading signal. On the other hand, low volume is more common with exhaustion gaps, which may be less reliable as they signal the end of a price trend.

What are other names for gap?

In trading, other names for “Gap” include “price gap,” “price void,” or simply “gap up” or “gap down” depending on the direction of the price movement.

In technical analysis, the term ‘gap’ is occasionally known by other names. For instance, gaps are also known as ‘area gaps’ or ‘trading gaps’ in stock market trading. In some contexts, gaps may be referred to as ‘discontinuities’ in price charts.

Regardless of the terminology used, all these terms refer to the same concept: an area on a price chart where no trading has occurred, creating a blank space or “gap”.

Are gaps significant in technical analysis?

In technical analysis, yes, gaps are significant as they often indicate sudden shifts in market sentiment or supply-demand dynamics, providing valuable insights for traders.

They provide insights into market sentiment, potential trading opportunities, and areas of support or resistance. A gap can signal the start of a new trend, a reversal of an existing trend, or a strong shift in market sentiment. The type of gap (common, breakaway, runaway, or exhaustion) can help traders understand the context of the price action and the potential future direction of the price.

Furthermore, gaps can act as technical support or resistance levels on a stock chart, influencing future stock price movements. Thus, understanding and accurately interpreting gaps is a crucial skill for any trader.

Summary

In conclusion, gaps might be a powerful tool in technical analysis, providing valuable insights into market sentiment, potential trading opportunities, and areas of support or resistance. However, you need to backtest by using quantifiable trading rules, and not apply the same rules on all markets and assets.

By understanding the different types of gaps and their implications, traders can make more informed decisions and enhance their trading strategies.

However, like all trading tools, gaps should not be used in isolation. They should be used with other indicators such as RSI, MACD, Williams %R, etc., and market context to provide the most reliable trading signals.