Five Tips for Trading Gaps

Gaps are events that jolt price up or down, leaving an open window to the last bar. Market folklore offers guidance on trading gaps, but classic wisdom such as "gaps get filled" doesn't tell us how to make profitable decisions when a gap suddenly appears on a favorite chart. So, how can traders take advantage of these unique price patterns?
First, we need to figure out what kind of gap we're dealing with. Certain trades work best with each gap type, so it is important to identify what type you're seeing. Traders should look at relative location to place gaps in the right category. In most cases, gaps will fall into one of three groupings:

1. Breakaway gaps appear as markets break out into new trends, up or down
2. Continuation gaps print approximately halfway through trends when enthusiasm or fear overpowers reason.
3. Exhaustion gaps burn out trends with one last surge of emotion and price movement.

Now, let's look at five tips for trading gaps effectively.

Tip 1: Use Market Psychology, as well as Price Location, to Identify the Gap Type

Generally speaking, gaps also fall into one of three "emotional" categories:

1. Breakaway gaps "surprise" because they appear suddenly on charts you've ignored.
2. Continuation gaps "exhilarate" because they pay off big as momentum accelerates.
3. Exhaustion gaps "frustrate" because they show up when your analysis points to a reversal.

Tip 2: Align Your Entry and Exit Strategy to the Specific Gap Type

For example, watch as an exhaustion gap shows up after a long rally or selloff. Then, enter the trade in the opposite direction of the trend in place before the gap occurs. These phenomena often mark the end of up or down trends, with this last burst of energy signaling a climax, ahead of a sharp swing in the opposite direction.
After an up trend, these gaps offer great signals to take profits on long positions and to enter new short sales. Alternatively, you can use them to cover short sales after down trends and enter new long positions. However, in both types of trends, it's best to get signal confirmation using technical indicators before taking new positions.
Here's a second example of gap and strategy alignment. Trade the primary trend on the first pullback to a breakaway or continuation gap. The odds favor a reversal back in the direction of the trend even if these types of gaps get filled. So, it makes sense to buy the low volume decline after a notable rally, or sell the low volume bounce after a notable selloff.
Markets often retest breakaway gaps right after they occur, but many bars can pass before price returns to test a continuation gap. Also, you can't trade a continuation gap if you can't find it, so here's an old technician's trick: Wait until you can count three distinct moves, up or down. Then, measure out the trend from start to finish, and look for a gap at the 50 percent level.
Once you've located the continuation gap, place a limit order within its boundaries and wait for a test to occur. The retracement, or move against the primary trend, should find support within the gap and reverse. However, as you can see with AK Steel, continuation gaps may fill for a few bars before they reverse. So, a defensive strategy will stand aside until the stock moves forcefully in the other direction before entering the position.

Tip 3: Know Your Time Frame

Examine gaps on the intraday and daily charts to get a clear view of support and resistance levels. Gaps cut through all time frames and trends but represent different phenomena in each one. For example, note how the exhaustion gap of the AKS Steel January to April rally is also the continuation gap of the smaller March to April rally.
In addition to this "3D" gap analysis, take time to distinguish between gaps in the direction of the trend and those moving against it. Countertrend gaps are especially important when they occur near big highs or lows. For example, a selloff gap right after a strong rally can produce considerable fear that often triggers good short sale entries.
Gaps through support and resistance levels can signal major break-outs and break-downs. Crowd emotions build so strongly at these price levels that the gap can set off a strong trend with rapid price change. Moreover, the greed or fear induced by these breakaway gaps can trigger additional gaps as the trend builds momentum.
Gaps that show up within narrow sideways patterns show less persistence and often fill with little warning or volume. These "common" gaps have little predictive value, so traders should avoid using them to make entry or exit decisions. Of course, the challenge once again lies in recognizing the correct gap type when it prints.

Tip 4: Mark Out Price Levels on Gaps to Find Key Decision Points

No easy formula shows traders how far a gap can travel and still remain healthy. But, it's best to apply common sense when observing pre-market action above or below the last closing price. The most important question for traders to consider at that time is this: Does the news or market environment justify the gap you'll see when the market opens?
Many traders place market orders before the open to get into their favorite gap plays. Unfortunately, this practice often yields the worst fills imaginable. So, it's better to take a few minutes after the open to plan your gap entry while you wait for better prices. In that regard, here are several gap entry strategies you can use when the session gets underway.

Find your entry by standing aside at the open and marking out the first-hour range on a 15-minute chart, with lines at the high and low. Then, take the trade when price finally moves out of this range even if it's a few days later. Alternatively, more aggressive traders can apply this strategy to the first half hour of the session, but tighter stops are required to manage the higher risk.
A buy signal issues when price exceeds the high of the range after an up gap. A sell signal issues when price exceeds the low of the range after a down gap. It's a relatively simple strategy that can get you into many profitable trades. But, if you decide to use this technique, a few caveats are in order to avoid whipsaws and other unprofitable traps.
First, the initial swing in either direction might last longer than anticipated, so stay flexible. If a trading range builds in 50 or 70 minutes instead of 60, go ahead and use those levels to define your range. Also, make sure to manage risk proactively because the range break might extend just a few pennies and then whipsaw in the other direction.
More defensive traders should stick with the first-hour-range strategy and avoid very short-term entry signals. An even lower risk approach is to let other market players take the bait during these range break-outs while you sit back, looking for midday pullbacks or consolidation patterns.

Countertrend movement after a gap generates other types of trading opportunities. The most obvious takes place at the support line in an up gap. We'll call these "reverse break" lines. Violation of the reverse break can trigger a quick selloff toward the gap fill line. This surge makes sense because everyone who enters an opening position in the gap direction is losing money when price falls out of the trading range.
The gap fill line marks support in an up gap and resistance in a down gap. The odds favor a swing in the other direction when it gets hit. However, this is a bad spot to enter positions because the reverse break line marks new resistance that must be overcome. The conflict between the lines can trigger whipsaws, until one side finally gives way.
The stock issues a renewed buying signal when it remounts the reverse break line and reenters the early trading range. In an up trend, this price action exposes hidden buying power that often precedes a rally to daily highs. The risk after this signal is well managed by placing a stop loss just below the reverse break line.

Tip 5: Gaps Have Memory

Finally, keep in mind that gaps can come back into play months or years later. For example, look for a major up gap to offer support even when it took place one or two years ago. For this reason, smart traders always look back at history when examining a favorite chart to identify any gaps that might help or hurt the position they want to take.