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Identifying and Trading Gaps with Technical Analysis
- Patrick Meier
- May 14, 2022
- 2 min read
Have you ever observed abrupt fluctuations in stock prices that create a noticeable break on the chart? These breaks are commonly known as price gaps and can present a profitable chance for traders. This article will delve into the concept of gaps, the various types of gaps, methods for recognizing them, and strategies for trading them through technical analysis.
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Definition of Gaps
Gaps materialize when there is a notable variance between a security's closing price and the subsequent day's opening price. These gaps emerge due to abrupt shifts in market sentiment, like unexpected earnings reports or sudden alterations in economic circumstances.
Varieties of Gaps
There are four primary gap types: common gaps, breakaway gaps, runaway gaps, and exhaustion gaps.
Common Gaps: These gaps are frequent within a trading range, typically small, and have a minor impact on the overall trend.
Breakaway Gaps: These gaps mark the start of a new trend and often come with high trading volumes, indicating a significant change in market sentiment.
Runaway Gaps: These gaps occur mid-trend, signaling a continuation of the current trend and offering trading opportunities.
Exhaustion Gaps: These gaps appear at trend endings, indicating a market sentiment reversal and are usually accompanied by low trading volumes.
Spotting Gaps
Identifying gaps is straightforward - on a chart, look for a price bar without overlapping price action from the previous bar, typically caused by post-market closing events like earnings reports or news releases.
Trading Gaps with Technical Analysis
Now that you grasp what gaps are and how to spot them, let's delve into trading them using technical analysis.
Market Analysis: Before gap trading, analyze the market to ascertain the prevailing trend using indicators like Moving Averages, Relative Strength Index, and MACD.
Gap Type Identification: Determine the gap type to devise an appropriate trading strategy - e.g., consider entering a long position for a breakaway gap and exiting a long position for an exhaustion gap.
Utilize Support and Resistance: Employ support and resistance levels to determine entry and exit points based on the gap's bullish or bearish nature.
Implement Stop Loss and Take Profit: Safeguard your capital and optimize profits by setting stop-loss and take-profit levels, possibly aided by indicators like Average True Range.
Trade Monitoring: Keep a close eye on your trade post-entry to ensure it aligns with your expectations and be ready to exit swiftly if needed.
Summary
Gaps present lucrative opportunities for traders. By comprehending gap types, employing technical analysis for identification and trading, traders can capitalize on sudden market sentiment shifts. Yet, always prioritize risk management and avoid overtrading beyond your risk tolerance.
