If you have an observant bend of mind, you may have noticed something interesting. In many stock charts, there are areas where the price moves sharply up or down, with almost no trading in between. This results in the formation of a gap in the normal price pattern.
The 4 Types of Gaps
There are 4 types of gaps – Common, Breakaway, Runaway, and Exhaustion gaps.
Common gaps usually occur almost regularly and don’t have much significance. These gaps are usually small – say, a stock closes at $60 one day and opens at $60.25 next day. These gaps are usually filled in the next few days. The figure below shows common gaps.
Breakaway gaps, on the other hand, are associated with a rapid change in the investor sentiment. This could happen due to earnings reports, or any major news events. Usually, stocks that are in a range start trending with a breakaway gap. The future price typically moves in the breakaway direction. The figure below shows a breakaway gap.
Runaway gaps usually occur during the middle of a prevailing trend, say an uptrend. This could happen when a catalyst like positive news brings in new investors who were waiting on the sidelines to get into the trade. Runaway gaps are also called as continuation gaps or measuring gaps. The figure below shows a runaway gap.
Exhaustion gaps happen at the end of the uptrend or downtrend. It signifies the end of the move and appears similar to a runaway gap. However, exhaustion gap is filled within a few price bars after the gap, unlike runaway gaps.
Other than these 4 gaps, there is a fifth type of gap called as an island cluster. Island Cluster comprises of a gap in the trending direction, followed by a mostly sideways period for the price, and then a gap in the other direction. This is a strong reversal pattern. The figure below shows Island Cluster gap.
How to Trade Gaps
The trading strategies for trading gaps are as follows:
- Choose trades in the same direction as the runaway gaps. This means that if a runaway gap occurs during an uptrend, going long on the stock may yield you a profitable trade. Similarly, if a runaway gap occurs during a downtrend, going short on the stock may be a profitable trade. A runaway gap generally does not fill before reaching its target. So, ideal stop-loss levels can be set based on this knowledge. For instance, for a bullish runaway gap, stop-loss just below the gap may be a good level. In case of a bearish gap, stop-loss could be placed just above the gap.
- Once you confirm that the candlesticks after the breakaway gap is stable, choose trades in the same direction as the move. This means going short if the breakaway happened downwards and going long in case the breakaway happened upwards.
- You can trade the exhaustion gap as soon as it occurs. Usually, the stock reverses as soon as an exhaustion gap is formed. So, go long if the exhaustion gap happened during a downtrend and go short if the exhaustion gap happened during an uptrend.
- Island cluster is one of the most reliable gap patterns. In case the island cluster appears at the end of a downtrend, make an entry above the breakaway gap, with the stop loss below the gap. In case the island cluster appears at the end of an uptrend, make an entry below the breakaway gap, with the stop loss above the gap.
Editor’s Note: Tara has put together over two dozen educational lessons that are focused entirely on technical trading. Access her lessons, for free, here.