Gaps are areas on a chart where the price of a stock (or
another financial instrument) moves sharply up or down, with little or no
trading in between. As a result, the asset's chart shows a gap in the normal
price pattern.
Now learn some basics, Gaps happens
because of basic fundamental or technical aspects. E.g., if a company's
earnings grown by many folds than expected, the company's stock may gap up the
next day. Similarly, a stock breaking a new high in the current session may
open higher in the next session, thus gapping up for technical reasons.
Classification of gaps:
- Breakaway gaps occur at the end of a price pattern and signals the beginning of a new trend.
- Exhaustion gaps occur near the end of a price pattern and signals a final attempt to hit new highs or lows.
- Common gaps cannot be placed in a price pattern – they simply represent an area where the price has gaped.
- Continuation gaps occur in the middle of a price pattern and signals a rush of buyers or sellers who share a common belief in the underlying stock's future direction.
How to deal with these Gaps:
Different analysts / traders has
their own way to deal with gaps, here are few popular strategies. Some traders buy
when major or technical factors favor a gap on the next trading day. E.g.,
they will buy a stock after spending few hours when a positive earnings report
is released, hoping for a gap up on the following trading day. Traders might
also buy or sell into highly liquid or illiquid positions at the beginning of a
price movement, hoping for a good fill and a continued trend. For example, they
may buy a currency when it is gaping up very quickly on low liquidity and
there is no significant resistance overhead. But some analyst / traders will
fade gaps in the opposite direction once a high or low point has been determined
(often through other forms of technical analysis). For example, if a stock gaps
up on some speculative report, experienced traders may fade the gap by shorting
the stock. Lastly, traders might buy when the price level reaches the prior
support after the gap has been filled.
Remember following when
trading gaps:
- Once a stock started to fill the gap, mostly it will not stop, because there is habitually no immediate support or resistance.
- Exhaustion gaps and continuation gaps predict the price moving in two different directions – be sure you correctly classify the gap you are going to play.
- Most retail investors who usually exhibit illogical excitement; however, institutional investors may play along to help their portfolios, so be careful when using this indicator and wait for the price to start to break before taking a position.
- Have a close watch on volume. High volume should be present in breakaway gaps, while low volume should occur in exhaustion gaps.
Source: Investopedia, Stockcharts
Tags
Investment