Gapping occurs when a stock or another trading instrument opens above or below the previous day’s close with no trading activity in between. This phenomenon can greatly influence trading strategies and market sentiment.
Types of Gaps
Common Gap
A common gap, often called a trading gap, typically arises during regular market fluctuations and does not signify any major trend change. These gaps are usually filled quickly.
Breakaway Gap
This type of gap occurs at the end of a price pattern and signals the beginning of a new trend. Breakaway gaps typically come with high volume and can indicate strong bullish or bearish momentum.
Runaway Gap
Also known as a measuring gap or continuation gap, it appears in the midst of a strong trend, suggesting the continuation of the existing trend. It usually occurs during periods of high interest in a stock.
Exhaustion Gap
This gap signals the end of a price move. It occurs near the end of a strong trend and can lead to a reversal, especially when followed by heavy trading volume.
Identifying Gaps with Examples
Example of a Common Gap
Consider a stock trading at $50 at the close of the market on Monday. On Tuesday, it opens at $51 but drops back down to $50.50 during the day. This interim increase without significant news is indicative of a common gap.
Example of a Breakaway Gap
If a stock closes at $75 on Wednesday and opens at $85 on Thursday due to a significant positive earnings report, this is a breakaway gap. The substantial price jump and accompanying volume signify a new bullish trend.
Example of a Runaway Gap
A stock that has been on a steady increase from $30 to $45 might experience a runaway gap if it opens at $48 during the ongoing trend, signifying strong investor interest and confidence.
Example of an Exhaustion Gap
After a prolonged upward movement, a stock closing at $100 may have an exhaustion gap when it opens at $110 but then drops back significantly, possibly indicating the end of the upward trend.
Trading Strategies Involving Gaps
Gap Trading Strategy
This involves identifying securities that are likely to gap and profiting from the difference in price. Traders use historical data, technical analysis, and news events to anticipate gaps.
Gap and Go Strategy
In this strategy, traders look for significant gaps in price and trade in the direction of the gap with the hope that the momentum will continue. This is commonly used for breakaway and runaway gaps.
Fade the Gap Strategy
Counter to the Gap and Go, this strategy involves trading against the gap direction, expecting the price to correct itself. This is often employed when common or exhaustion gaps are identified.
Historical Context of Gapping
Historically, gaps have been closely watched by traders as indicators of market sentiment and investor behavior. With high-frequency trading and instantaneous news dissemination, gaps have become more frequent and pronounced.
Frequently Asked Questions
What Causes Gapping?
Gapping is primarily caused by news events, earnings reports, or significant market movements that occur outside trading hours.
Are Gaps Always Filled?
Not necessarily. While common gaps are often filled, breakaway and runaway gaps may not be filled for extended periods, if at all.
Can Gapping Occur in Markets Other Than Stocks?
Yes, gapping can occur in any market where trading ceases at the end of a trading day and resumes the next day, including commodities, cryptocurrencies, and forex.
Summary
Gapping is a critical concept in trading that involves the opening price of a security being significantly higher or lower than its previous closing price. Understanding the types of gaps and their implications can provide traders with valuable insights and strategies for making informed trading decisions. Whether employed in stock markets or other trading arenas, recognizing and capitalizing on gaps can be a powerful tool in a trader’s arsenal.
