There are several approaches associated with trading in the stock market.
One such approach which requires a lot of research and precision is that of Gap Trading.
But, before we completely delve into the features and properties of Gap Trading, let us first understand what “Gaps” are.
Gaps can be defined as areas on a chart where the price of a financial instrument moves sharply up or down, with the space of little or no trading happening in between.
It is a change in price levels between the close and open ends of two consecutive days.
In order to fill this gap, the price level requires moving back to the original pre-gap level.
Gaps occur due to underlying fundamental or technical factors.
There are different types of Gaps which can be seen on a stock chart. They are:-Breakaway Gaps
How do we define Gap Trading?
Gap Trading can be defined as a methodical approach to buying and short selling stocks.
Traders can watch a price gap from the previous close of a stock and identify the trading range to understand when to buy or sell a stock.
When the stock rises above the trading range, it signals a buy and when the stock falls below the trading range, it signals a sell.
Moving on, let’s look at the four different kinds of situational Gaps that can occur while Gap trading in the stock market.
We would be looking at Full and Partial Gap Ups and Gap Downs.
The main difference between a Full and a Partial Gap is risk and potential gain.
It has been noticed by traders around the world how stock gapping completely above the previous day’s high results in a significant change in the market’s desire to own or sell it.
Apart from this, we see how full gapping stocks generally trend farther in one direction than stocks which only show a partial gap.
According to stockcharts.com, “a smaller demand may just require the trading floor to only move price above or below the previous close in order to trigger buying or selling to fill on-hand orders.
There is a generally a greater opportunity for gain over several days in full gapping stocks.
If there is not enough interest in selling or buying a stock after the initial orders are filled, the stock will return to its trading range quickly.
Entering a trade for a partially gapping stock generally calls for either greater attention or closer trailing stops of 5-6%.”
Full and Partial Gap Ups
A Full Gap Up occurs when the opening price is greater than yesterday’s high price.
Full Gap Up as a feature can further on be divided into:
Full Gap Up-Long, Full Gap Up-Short, Full Gap Down- Long, and Full Gap Down-Up.
A Partial Gap Up occurs when today’s opening price is higher than yesterday’s close and not higher than yesterday’s high.
Full and Partial Gap Downs
A Full Gap Down occurs when the opening price is less than yesterday’s low. A Partial Gap Down occurs when the opening price is below yesterday’s close, but not below yesterday’s low.
A Partial Gap Down as a feature can be further divided into:
Partial Gap Down-Long, Partial Gap Down-Short, Partial Gap Up- Long, and Partial Gap Down- Short.
As part of Gap Trading, several traders use a disciplined set of entry and exit rules to signal trades and minimize risk.
Gap trading strategies can be applied to weekly, end-of-day, or intraday gaps.
It is important for longer-term investors to understand how these gaps work, as the ‘short’ signals can be used as an exit signal to sell financial holdings.
Further on, we must note that each of the four gap types has a long and short trading signal, defining the eight gap trading strategies, namely: Partial Gap Up: Long, Partial Gap Up: Short, Partial Gap Down: Long and Partial Gap Down: Short.
Also, the basic doctrine behind gap trading is to wait for an hour after the market opens for the stock price to establish its range.
End of the Day Gap Trading
There are several scans available to us today which help the end-of-day traders review stocks with the best potential.
In case one notices an increase in volume for stocks gapping up or down is a strong indication of continued movement in the same direction of the gap.
At the same time, a gapping stock that crosses above resistance levels is known to provide sure and reliable entry signals.
Similarly, a short position would be signaled by a stock whose gap down fails support levels.
To conclude, Gap trading strategies can be defined as a structurally defined trading system which includes the use of specific factors to enter or exit the market.
Several seasoned traders around the world believe that the easiest method for understanding one’s own ability to deal in gap trading is to first understand ‘paper trade’.
Paper trading does not involve any real transaction; instead, you can note down about entry and exit signals and then subtract commissions as well as slippage to calculate your potential gain or loss from the trade.
Nevertheless, in gap trading we will not find either the tops or bottoms of a stock’s price.
Thus, gap trading is considered to be one of the most preferred trading approaches by traders around the world due to its simplicity and the lack of complicated rules-structure.