Gap Trading: How to Trade the Gaps

A price gap occurs when there is a difference between the closing price one day and the opening price the following day. Price gaps are important in technical analysis because they show a strong change in value from one day to the next. There are multiple types of gaps, from common gaps, which are generally ignored, to full gaps, which show an important shift in sentiment when sufficiently large.

Gaps are often the result of overnight news, such as earnings or an unexpected company-specific event. Upon understanding the types of gaps, strategies are employed to take advantage of them.

Be sure to also learn about a Short-Squeeze and How to Profit From One.

The Appeal of Gap Trading

screen with tickers and prices

Gaps are highly visual and easy find using a stock screener. Once found, a gap is traded with precise protocols (vary by strategy). This produces a positive trade expectation where the profit potential is greater than the risk. This is the desired outcome of most strategies. Since gaps are associated with a volatile move, the potential gains from trading the aftermath of a gap can be quite large as volatility and emotions continue to run high in the days and weeks that follow.

The gap trading strategy below isn’t time consuming. This is useful for traders who don’t have time to sit in front of their trading screens all day.

Visual Guide to Gaps

There are three main gap types, and three more which have relevance for analytical purposes.

Common Gap is frequent, and not of concern. For most stocks, a common gap is when the open price is within 1% of the prior close. In a volatile stock, a common gap may be up to 3% or 4%. In a “tame” stock, common gaps will be approximately 0.5% of less.

Common gaps don’t show a strong shift in buying or selling pressure, but instead show differences in price that can be reasonably expected from day to day. Volume helps verify if it is a common gap. If there isn’t an increase in volume on the gap, and it is small, it is probably common and insignificant.

Be sure to read our Ultimate Guide to Analyzing Trading Volume.

All charts courtesy of StockCharts.com

common price gaps
Figure 1. Common Price Gaps

Full Gap occurs when the open price is completely outside the price range of the prior day.

A full gap higher is when the open price is above the previous day’s high, and with a full gap lower the open price is below the previous day’s low.

full price gaps
Figure 2. Full Price Gaps

The Partial Gap is when the open is different than the close, but the open is within the price range of the previous day.

A partial gap higher is when the open price is below the previous day’s high, but above the prior close. A partial gap lower is when the open price is above the previous day’s low but below the prior close. Most partial gaps are of little concern.

partial price gaps
Figure 3. Partial Price Gaps

The above types classify the gaps that occur, with full gaps being the most useful for trading purposes, especially when there is a big percentage difference between the prior close and the open price.

These big gaps are further classified as breakawayrunaway and exhaustion. At the time they appear they are essentially the same – a big full gap. It is only when looking at the broader trend and the aftermath of the gap does it become apparent which type of gap it is.

Breakaway gaps occur after a consolidation or chart pattern (such as a triangle or head and shoulders pattern) and signal a strong breakout. Runaway gaps occur during strong trends and show the trend is accelerating. An exhaustion gap occurs near the end of the trend, giving one last strong burst in the trending direction before the trend reverses. Volume on all these gaps is much higher than average.

See also Trend Reversals: How to Spot and How to Trade.

The strategy discussed shortly is most useful when traded following a breakaway gap, such as the one shown in Figure 4.

breakaway price gap
Figure 4. Breakaway Price Gap

Finding Gap Trade Candidates

Any stock that has a price gap of 10% or more is one to monitor closely. Stock screeners such as a the predefined scans on StockCharts.com or the Top Gainers and Top Losers on Finviz.com or Yahoo! Finance will provide a handful of stocks that gapped. See our list of the 10 Best Stock Screeners.

Monitoring gaps in real-time isn’t required for the strategy below. Rather the levels the price gapped from in the past will provide potential trade levels for future trades.

Gap Trading Strategy

Following a significant gap—roughly 10% or more—the price will often, eventually, move back to test the point from which the gap originated. This is referred to as “filling the gap.”

If the gap was higher, the price moves back to test the price on the day prior to the gap higher. This presents an opportunity to go long. A buy order is placed near the close of the day prior to the gap. A target is placed near the recent high, and a stop is placed below support prior to the gap, or several percent below the entry price.

long entry on filled price gap
Figure 5. Long Entry of Filled Price Gap

If the gap was lower, the price often moves back to test the price on the day prior to the gap. This presents an opportunity to go short. A short entry order is placed near the close of the day prior to the gap. A price target is placed near the recent low. A stop is placed above resistance prior to the gap, or several percent above the entry price.

Short Entry on Filled Price Gap
Figure 6. Short Entry on Filled Price Gap

The drawback to this strategy is that the price may not pullback, and instead keep trending. In this case, trend trading strategies can be employed so opportunities aren’t missed. See: Best Trend Trading Setups with Examples.

There is also potential that the price will continue to move right through the entry location, hitting the stop. Waiting for a bullish engulfing pattern on a long trade, or a bearish engulfing pattern on a short trade, could be used to indicate that the price is moving back in the anticipated/trade direction before entry.

The Bottom Line

Gaps occur all the time, although common gaps and partial gaps aren’t usually of importance to traders. Full gaps on the other hand, which move significantly away from the previous close, show a strong shift in investor sentiment. When a price gaps 10% or more, the stock will often “re-test” the area the price originally gapped away from. This presents a trading opportunity. Stocks that have gapped can be recorded and monitored for future trades. Use freely available stock screeners to find stocks that have gapped.

Cory Mitchell