Gaps

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While trading the markets, we come across many types of price action and gaps are one of them. It is indeed interesting to know whats the driving force behind these gaps and how can we really incorporate the concept of gaps in our trading. There would be days when we get gap up or gap downs. Understanding these gaps and trading them can be very juicy. But before we attempt to trade these gaps, it is important to understand them. Let's take various cases and make an attempt on how can we trade them.

Whenever we talk of gap, it must be a visual gap. Visual Gap is something which is very apparent and clear on charts. We are not talking in terms of points or %ges but just visual gaps.

There could be many types and gaps and there is a method to take care of each one of them.

Breakaway Gaps

Breakaway gaps occur when the price breaks out of a congestion zone. Congestion zone is basically a price range where the scrip has been trading for while. The top of this congestion zone acts as Resistance and the bottom acts as Support. To breakout of these areas, require a lot of momentum, volumes etc.. Volume needs to pick up not only for the enthusiasm for the Breakout or breakdown, but also for people caught on the wrong side of trade.

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In case of breakaway gap, we expect the momentum to continue in the direction of trade. So, if we have a breakaway gap up, we would be looking at a long trade. And in case of a breakaway gap down, we would be looking at a short trade. Allow the 1st 5min bar to form in case of breakaway gap, and go long above this bar in case of gap up or go short below this bar in case of gap down.

Continuation Gaps

Continuation gaps occur in the middle of a trend and signal a rush of buyers or sellers who share a common belief on the continuation of the trend in the same direction for some more time.

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In this case we expect the trend to continue in the same direction, so would like to take a trade in the direction of the gap. In this case too allow the 1st 5 min bar to form and we go long above the 5 min bar in case of a gap up, and go short below the 5 min bar in case of a gap down.

Exhaustion Gaps

Exhaustion gaps happen near the end of a trend. Many times these are the first signs of end of the present move and reversal of trend. Let us suppose we have had an extended upmove, then a WRB, some more bullish bars and then again a WRB and then continuation of trend for some more time, and then a huge gap up with huge volumes and vice versa for downtrend and gap down. This is exhaustion gap.

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In the case of exhaustion gap, we expect the market to reverse the trend. So, in case of gap up after a large uptrend, we allow the first 5 min bar to form and look to short the break of the low of this bar. Similarly in case of gap down after a large downtrend, we look to go long on the break of high of the first 5 min bar.

Now we have seen the gaps where Exhaustion gaps and Continuation gaps are in the direction of the trend, and Breakaway gaps are breakouts or breakdowns out of a range. But there are more possibilities on how a gap can occur. Let us look at what other possibilities are there and what other types of gaps can we have.

Gap down when the market is in uptrend

While the charts show that market is in uptrend, we might suddenly get a gap down opening. We are not interested in the reason why this happened, instead we are interested in how tackle or profit from this situation. A gap of this kind, could imply sudden panic which might cool down once the market is opened or this might be change of the trend. So, we wait for the first 5 min bar to form and look forward to go long if the high of this bar is taken out and go short if the low of this bar is taken out.

Gap up when the market is in downtrend

This is exact opposite situtation of the above. The charts show that the market is in downtrend, we suddenly get a gap up opening. In this situation, again we wait for the first 5 min bar to be complete, go long if high is taken out and go short if low is taken out.


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