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How to trade gaps in Stock Market Charts

There are four types of gaps :

Common Gap
Breakaway Gap

Gaps are formed on daily bar charts where no trading has taken place. In an upside gap for example, a gap would be formed if the open is higher than the previous bar’s high (Murphy definition). A downside gap would be formed if the open was lower than the previous bar’s low. These initial gapping moves form true gaps when at the end of that trading day the gap is left unfilled. So in an upside gap, today’s low is higher than the previous bar’s high, in a downside gap today’s high is lower than the previous bar’s low.

Common myth: All gaps must be filled. This a very tempting intra-day strategy but is strictly speaking, not true.

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Common Gap

This type of gap generally occurs in the middle of trading ranges or in thinly traded markets. Chartists tend to ignore the common gap but futures traders are always keen to use the common gap with the following points in mind:
1.Every gap must be filled – which remember is not strictly speaking true
2.The gap high and low and even the close and open can be used as support and resistance levels.
3.Common gaps offer little to trend analysis or confirmation of a pattern breakout or reversal and are usually ignored by chartists.

Breakaway Gap

This type of gap can occur at the completion of a significant pattern. A breakaway gap gives a strong signal that the market has started a new trend or phase of a trend. This gap has more significance if it is left unfilled, and should remain ‘unclosed’ to have validity. On an upside gap, the high of the previous bar (the gap low) is considered to be strong support. On a downside gap the low of the previous bar is considered to be strong resistance.

1.Breakaway gaps are seen as patterns are completed and stops are triggered, the market may be receiving a ‘shock’.
2.Breakaway gaps can be used as support or resistance as orders will be left at these levels to cut losses or initiate trades.
3.Once the breakaway gap is confirmed (the gap holds on a test) the trend move should be strong.

Runaway Gap

Once the trend is underway prices may leap forward to form a gap or even a series of gaps. This may have some strong volume associated with it. The runaway gap offers the same support and resistance studies that the breakaway gap does.
1.The runaway gap sometimes occurs in the middle of the trend move and can be a ‘measuring gap’.
2.The runaway gap occurs as the trend gathers more ‘believers’, new funds flow into the market to re-enforce the trend.
3.The runaway gap also occurs as ‘stale’ longs or shorts cut their positions and take their losses. This can be on the back of news, shocks to supply/demand, or simply too much ‘pain’ in existing positions.Exhaustion Gap

Once the trend is well established and most targets/objectives have been met, an exhaustion gap may be seen. This will appear like another runaway gap, but the price action will be critical. Basically, once the gap is seen, but is then filled and closed, the exhaustion gap could be in place.
1.Exhaustion gap is seen at the end of the trend move.
2.Exhaustion gap is confirmed as the gap is filled and closed.
3.Exhaustion gap signals a trend change

Island reversals

Island reversals occur when the market gaps higher with an upward exhaustion gap (or lower with a downwards exhaustion gap), trades in a narrow range for a few days and then gaps lower again. This leaves an “island” of prices, surrounded by unfilled space and usually signals a trend reversal.

Opening Gaps are worth watching out for in intraday trading, especially in futures prices, but dont get too obsessed with them!!