Gap trading is a powerful strategy that many traders use to capitalize on price movements that occur between trading sessions. Gaps form when a stock’s price opens significantly higher or lower than its previous closing price, creating trading opportunities. I’ve personally found that understanding the different types of gaps, their causes, and how to trade them can lead to consistent profits.
What Are Gaps in Stock Trading?
A gap occurs when there is a discontinuous price movement in a stock chart, usually due to after-hours news, earnings reports, or major economic events. These gaps signal potential trading opportunities, but not all gaps are the same. The key is knowing how to differentiate between them and determining the best trading strategy.
Types of Gaps
Gaps can be categorized into four main types:
- Breakaway Gaps – Occur at the start of a new trend and indicate strong momentum.
- Runaway (Continuation) Gaps – Appear during an existing trend, reinforcing the movement.
- Exhaustion Gaps – Form at the end of a trend, suggesting a possible reversal.
- Common Gaps – Happen randomly with no significant news catalyst and often fill quickly.
Here’s a table summarizing the key characteristics of each type:
| Gap Type | Location in Trend | Indicates | Filling Likelihood |
|---|---|---|---|
| Breakaway Gap | Beginning | Strong new trend | Low |
| Runaway Gap | Middle | Trend continuation | Moderate |
| Exhaustion Gap | End | Reversal | High |
| Common Gap | Random | No strong signal | Very High |
The Psychology Behind Gaps
Gaps are driven by investor sentiment and institutional actions. When major news breaks outside market hours, traders react by placing buy or sell orders that trigger a price gap at the open.
For example, if a company reports stellar earnings after the market closes, buyers rush in the next morning, creating an upward gap. Conversely, if bad news surfaces, panic selling causes a downward gap.
How to Trade Gaps Profitably
Over the years, I’ve learned that not all gaps should be traded the same way. Each type requires a specific approach.
1. Trading Breakaway Gaps
These gaps suggest a strong new trend, making them ideal for momentum trading.
- Entry Point: Enter after the gap forms and volume confirms the trend.
- Stop-Loss: Place below the gap’s low (for bullish gaps) or above the high (for bearish gaps).
- Profit Target: Ride the trend using moving averages or Fibonacci retracements.
Example: Breakaway Gap Trade
Suppose XYZ stock closed at $50 but opened at $55 due to an acquisition announcement. The volume is high, and technical indicators confirm bullish momentum.
- Entry: Buy at $56 (confirmation of continuation)
- Stop-Loss: $53 (below the gap)
- Target: $65 (based on Fibonacci projection)
2. Trading Runaway Gaps
Runaway gaps reinforce an existing trend. The key is trading in the trend’s direction.
- Entry Point: Buy (or short) when the gap aligns with the trend.
- Stop-Loss: Below the gap (for uptrends) or above the gap (for downtrends).
- Profit Target: Use trendlines or moving averages.
3. Trading Exhaustion Gaps
These gaps indicate that a trend is losing steam, making them ideal for reversal trades.
- Entry Point: Enter when reversal confirmation occurs (e.g., candlestick patterns like engulfing or shooting star).
- Stop-Loss: Beyond the recent high (for shorts) or low (for longs).
- Profit Target: Previous support/resistance levels.
Example: Exhaustion Gap Trade
ABC stock has been rallying for weeks, closing at $120. It gaps up to $130 but starts falling midday.
- Entry: Short at $127 (confirmation of reversal)
- Stop-Loss: $132 (above the high)
- Target: $115 (prior support)
4. Trading Common Gaps
Since common gaps lack significant news backing, they usually fill quickly. A mean reversion strategy works well.
- Entry Point: Enter when price starts filling the gap.
- Stop-Loss: Beyond recent highs/lows.
- Profit Target: Full gap closure.
Statistical Data on Gap Trading Success Rates
Studies have shown that gap-filling behavior varies based on market conditions:
| Market Condition | Gap-Fill Rate |
|---|---|
| Bull Market | 50-60% |
| Bear Market | 70-80% |
| Earnings Gaps | 30-40% |
Risk Management in Gap Trading
Trading gaps can be profitable but also risky. I always manage risk using:
- Position Sizing: No more than 2% of capital per trade.
- Stop-Loss Orders: To protect against sudden reversals.
- Pre-Market Analysis: To gauge sentiment before the opening bell.
Historic Examples of Gap Trading
1. Tesla’s Breakaway Gap (2020)
In early 2020, Tesla (TSLA) gapped up after a strong earnings report, rising over 50% in a few weeks. Traders who caught the gap early saw significant profits.
2. Apple’s Exhaustion Gap (2008)
Before the financial crisis, Apple (AAPL) showed an exhaustion gap that signaled a market-wide selloff. Short sellers profited as the stock declined.
Conclusion
Gap trading is a valuable strategy, but success requires understanding the different gap types, trading them correctly, and managing risk. With the right approach, gaps can provide profitable opportunities in the stock market.
