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Occasionally, there comes a point when the stock market closes for the night and re-opens in the morning and there has been no trading activity in-between for a particular share. This is called gapping. A gap stock has usually experienced an unexpected change in price overnight, due to external factors such as supply and demand.
The share market can be volatile and this results in frequent gaps in the market. Gapping most commonly happens overnight, although it can also happen during daily trading hours when there is a rapid jump in price of a stock. Stock gaps are caused by a number of reasons, such as earnings reports, news announcements and other economic indicators that lead to an increased supply and demand for the financial instrument.
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What is gap trading?
Considering the above information, what does ‘trading the gap’ mean? In simple terms, traders identify gaps between opening and closing prices on a trading chart where there has been volatile action, and can use this to devise an appropriate trading strategy. They will then need to calculate potential entry and exit points for their trades. Traders often use event-based strategies when there is a market gap, as they can predict but not guarantee what will happen next.
There are also different classifications of gaps, as they do not all represent the same price pattern or trend on a price chart. These can be split into the following:
- Breakaway gaps: these happen at the end of a pattern and signal the beginning of a new trend.
- Common gaps: these represent an area where the price has gapped but nothing else.
- Continuation gaps: these are caused by a rush in supply and demand that occur in the middle of a price pattern.
- Exhaustion gaps: these happen near the end of a pattern and signal a last attempt to hit price highs or lows.
Stock gap analysis
There are two levels of gapping within the stock market: partial and full. Partial gapping is when a share’s opening price is higher or lower than the previous day’s close but within the typical range, whereas full gapping is when a share’s opening price is outside of the range. A full gap shows that the market was particularly volatile overnight and the market sentiment for this share has changed.
The imbalance between supply and demand of a particular stock pushes its price outside of support and resistance levels overnight, which leads to gaps in a chart. Sometimes, this gap is filled back to its original level. This can indicate that the price rally was misunderstood, too optimistic, or investors have had a more thorough look at the earnings report and spotted weaknesses. This can lead them to sell their positions, bringing the share’s value back to its original level.
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How to find gap up stocks
Gap up stocks are relatively easy to spot on a price chart. Gaps in the market are shown as blank spaces between candlesticks, and gap up stocks are followed by a green candlestick on the open. This shows that there is a rally in price, which can either signal a new trend or it may be an anomaly. Consider the example below, where a large space in the price chart is followed by a green candle, signalling that there has been an external event leading to the asset’s jump in price.
How to find gap down stocks
Gap down stocks follow the same structure as gap up stocks, in reverse. For example, the below price chart shows two rapid declines in price in a 30-minute timeframe. The blank gap in the market is followed by a red candlestick, which signals that there has been a negative decline in price outside support and resistance levels. Although the price starts off in an uptrend, this market gapping soon reverses the stock into a downtrend.
Trading opening gaps
When thinking about identifying buying and selling opportunities, traders can use gap trading rules to devise a trading strategy. Remember that not every gap represents the same opportunity, but we can make predictions based on market activity to find possible low-risk and high-reward trades.
Gap trading strategies
- A gap up stock experiencing a rally in price in a downtrend provides a good opportunity to short sell the stock.
- A gap up stock in an uptrend provides a good opportunity to buy and hold a long position.
- A gap down stock experiencing a decline in price in an uptrend provides a good opportunity to buy.
- A gap down stock in a downtrend provides a good opportunity to short sell.
Gap trading system
We offer over 9,000 shares and ETFs to trade on our award-winning trading platform*, Next Generation. The platform is especially effective for gap trading, as our clients are able to choose from a wide range of chart types, drawing tools and price projection tools in order to display data as clearly as possible. This way, you can study the price action of each individual stock to spot any gaps within its trend.
The most effective gap stocks to trade in the share market are those that are more volatile, and thus have more price fluctuations. Therefore, you should consider the sector that you would like to trade in. For example, oil and gas, pharmaceutical and retail stocks are considered particularly volatile sectors to trade, especially in the face of adverse economic conditions or a national recession.
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