In this article, we will discuss
- What is a Gap?
- Why do Trading Gaps Occur?
- The Different Types of Trading Gaps Based on Price Charts
- The Different Types of Trading Gaps Based on Price Action — And How to Trade Them
- Conclusion
When you track the price of any stock or security, you will no doubt notice a common phenomenon. The opening price for a new trading session is rarely the same as the closing price in the previous trading session. For instance, a stock may close at Rs. 234.50 today and, when the market opens for trading tomorrow, may begin trading at Rs. 250.00.
This phenomenon — where there is a difference between the closing price of a stock or security in one trading session and its opening price in the next session — gives rise to the practice of gap trading.
Let us check out what a gap means, why it occurs and how you can start leveraging it effectively.
What is a Gap?
A gap refers to the region in a price chart where no trading activity occurs — yet there is a price change from the previous trading session. Generally, prices of securities in the financial market change based on the prevailing demand and supply dynamics.
However, sometimes, even when there is no buying and selling activity — such as when the market is closed — the prices of stocks and securities may be affected by other factors. As a result, when the market opens next, the prices change to reflect the new conditions that occurred during the closing hours.
This results in a gap between the closing price of the previous session and the opening price of the next session. A gap can never be accurately predicted. You can only anticipate the direction in which a stock's price may move due to aftermarket events. However, the precise direction and magnitude of a gap can only be studied retrospectively. This is why certain trading strategies are formulated after the market reopens and a gap has been established.
Why do Trading Gaps Occur?
To further understand the nuances of trading gaps, you need to be clear about why these gaps occur. What makes the opening price of a stock jump higher than or fall below the previous session’s closing price? Let's find out.
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Overnight News
One of the most common reasons for gaps in price action is any overnight event or news that impacts the stock price directly or indirectly. This may range from company-specific events to broader geopolitical developments. Positive news may cause a jump in the price when the market opens, while negative news may result in a decline.
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Corporate Actions
Corporate actions include dividend declarations, earnings reports, stock split announcements and more. These corporate actions can also lead to positive or negative gaps in the price of stocks and securities. If such announcements are made when the markets are closed, the price in the next trading session may reflect the effects of such corporate actions.
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Economic Data Releases
The Reserve Bank of India (RBI) or the central government may release key economic data and reports that could also result in price gaps. Some examples of such data include GDP figures, employment data, inflation reports and the outcomes of the RBI’s Monetary Policy Committee (MPC) meeting. Based on what such data includes, the price gaps in stocks and securities may be positive or negative.
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Aftermarket Trading Activity
Many traders place aftermarket orders for stocks and securities. These orders are not executed right away. Instead, they are queued and executed when the market opens for the next trading session. Before they are executed, they are matched with relevant orders in the premarket session. The change in demand and supply based on such aftermarket orders can drive the price upward or downward during the next trading session.
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Shifts in Market Sentiment
Sometimes, the market sentiment may shift overnight — either with regard to the market as a whole or with regard to a particular sector or stock. Such shifts in investor sentiment can also directly affect the opening price of a stock or security when the market opens next. These changes are impossible to anticipate, so it is best to account for them when you want to initiate a new trade or exit a current position.
The Different Types of Trading Gaps Based on Price Charts
When you study price action charts, it's easy to spot a price gap. However, you also need to know how to identify the different types of gaps based on the triggers that caused the changes. Here are 4 such gaps that are easily identifiable on price charts.
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Common Gap
True to their name, common gaps occur more frequently in the market than other types of gaps. They are caused by generic market forces and have no specific events or news as triggers. Since they occur in the course of regular trading, these gaps are generally small and are accompanied by regular trading volumes. They are also easily bridged when the stock price retraces its path back to the pre-gap levels over a few trading sessions.
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Breakaway Gap
A breakaway gap generally occurs after a period of price consolidation — which is when the prices are not moving strongly upward or downward. Instead, the price movements during consolidation occur within a defined range. The upper limit of this range is the resistance level, while the lower limit is the support level.
If the buyers gain dominance after the consolidation phase, the price breaks out past the resistance level and moves upward. Here, a positive gap may occur — where the opening price is above the previous day's closing price. If the sellers have the upper hand, the price breaks down below the support level after the consolidation phase and continues to decline. This may result in a negative gap — where the opening price is below the previous day's closing price.
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Runaway Gap
Unlike a breakaway gap, which occurs when the price breaks out of the support or resistance level, a runaway gap occurs in the same direction as the current trend. So, it is also known as a continuation gap. It is triggered by news or events that add to the prevailing market sentiment around a stock, thereby leading to accelerated buying or selling action.
For instance, if a company is already bullish and declares positive quarterly results, the demand for the stock may shoot up as more traders decide to buy the stock. This may cause the price on the next trading day to be significantly closer than the previous day's closing.
Similarly, in a downtrend, if there's sudden news about a company's litigation going unfavourably or any other such negative news, existing shareholders may want to offload their investments as quickly as possible. This may lead to a negative gap, where the price falls quickly and opens much lower the next day.
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Exhaustion Gap
An exhaustion gap occurs at the end of a sustained upward or downward trend. It is accompanied by a significant reversal in price as well as high trading volume. The gap occurs in the direction opposite to the prevailing trend, indicating that there is a weakening or exhaustion in the current momentum in the market.
This means that if an exhaustion gap occurs at the end of a downtrend, it is not followed by new lows. Or, if it occurs at the end of an uptrend, you will not find any new highs thereafter.
The Different Types of Trading Gaps Based on Price Action — And How to Trade Them
The types of trading gaps outlined above are generally discussed in technical analysis theory. However, if you want to implement practical gap trading strategies, you need to wait for at least an hour after the opening bell to give some time to the stock to establish a price direction and momentum. Furthermore, to decide whether to take long or short positions in the market, you need to look at gaps differently, as outlined below.
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A Full Gap Up
A full gap up happens when the opening price in a trading session is above the highest point of the previous trading session. For instance, say the highest price a stock achieves today is Rs. 104. If the opening price of the stock tomorrow is Rs. 107, it is considered to be a full gap up.
How to trade a full gap up:
You can take a long position or a short one after a full gap up. One of the best ways to initiate a long position would be to check the 1-minute chart for the first hour after the gap up and locate the high point in this period. Then, set your buy order two ticks above this price point. If the price rises steadily after the gap up, a long position may be justified.
However, if the buying pressure is not enough and the price falls below the opening gap, a short position may be better. To find the ideal entry point in this case, check the 1-minute chart for the first hour after the gap up and locate the low point in this period. Then, set your sell order two ticks below this price point.
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A Partial Gap Up
A partial gap up happens when the stock opens at a price above the closing price of the previous trading session (but below its highest point). For instance, say a stock achieves a high of Rs. 104 today but closes at Rs. 97. Now, if the opening price of the stock tomorrow is Rs. 100, it is considered to be a partial gap up.
How to trade a partial gap up:
You can trade a partial gap up in the same way as you trade a full gap up. The trading strategies can be similar, but make sure you establish the market direction before deciding whether to take a long or a short position.
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A Full Gap Down
A full gap down is when a stock opens at a price below the lowest point of the previous trading session. For instance, if the lowest price a stock achieves today is 80 and if the opening price of the stock tomorrow is Rs. 75, it is considered to be a full gap down.
How to trade a full gap down:
As with a full gap up, you can initiate long or short positions after a full gap down too. That said, it is quite rare for a stock’s price to climb immediately after a full gap down. However, if you notice this kind of price movement in the first hour following the gap down, you can enter a long position at a price that is two ticks more than the previous session’s low point.
Conversely, if the price continues to fall, you may want to take a short position in the market. The ideal entry price point for this trade would be two ticks below the lowest point achieved during the first hour after the gap down.
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A Partial Gap Down
A partial gap down is when the stock opens today below the closing price of the previous trading session (but above its lowest point). For instance, say a stock achieves a low of Rs. 59 today but closes at Rs. 67. Now, if the opening price of the stock tomorrow is Rs. 63, it is considered to be a partial gap down.
How to trade a partial gap down:
If you want to take a long position after a partial gap down, you can set the entry two ticks above the highest point in the first hour of trading. Conversely, if you want to take a short position, you can find the lowest point in the first hour and set the entry two ticks below this price.
Conclusion
Identifying price gaps and implementing the necessary strategies gets easier with practice. You may already have come across trading gaps several times during your past trades. However, you may not have been aware of how to leverage them to initiate long or short positions suitably. Now that you know how to do this, you can tap into the trading opportunities presented by such gaps in trading activity more effectively.
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