A price gap in trading is a special situation where a space appears between two candlesticks in a chart. This gap happens when there is an imbalance between demand and supply of an asset in the market.
Although gaps can happen during a trading session, they mostly happen when the market opens. An up gap happens when there is more demand than supply of an asset while a down gap happens when there is more supply. Trading gaps happen in all types of assets, including stocks, exchange-traded funds, commodities, and currencies.
In most cases, gaps form when there is major news affecting a certain asset. In stocks, an up gap can happen when a company releases excellent results during extended hours. Trading forex, a gap can happen when a central bank delivers an unexpected interest rate decision. On the other hand, in crude oil, it can appear when there is a major geopolitical conflict in the Middle East or an unexpected OPEC meeting results.
As a trader, understanding what gaps are and how they form can help you become a better trader. It can also help you identify reversals and continuation patterns in the market. The chart below shows a good example of a down gap on the USD/JPY pair.
Types of gaps and how to trade them
Broadly, there are two main types of gaps in the market; up gap and down gap.. Other common types of gaps are common gaps, breakaway gaps, runaway gaps, and exhaustion gaps.
Professional gap (pro gap)
A pro gap is a type of gap that happens and then continues with that trend. This gap is usually triggered by several fundamental factors like economic data, geopolitical issue, or an action by the central bank.
When a pro gap happens, the asset’s price will continue moving in that direction for a considerable amount of time. As you will see below, it differs from a novice gap, which happens and then reverses, as shown in the USD/JPY chart above.
In most cases, a pro gap usually forms when an event happens and pushes the price higher or lower. In case of an up gap, demand for the asset continues, causing the price to continue rising. Similarly, in case of a down gap, when the event happens, the selling pressure continues for a significant amount of time. In other words, in a pro gap, a reversal pattern does not happen immediately.
Notably, a pro gap usually happens in the opposite direction of the chart. A good example of this gap in action is shown in the Tesla chart below. In this chart, we see that Tesla stock was trading in a downward trend when an up gap happened. After it happened, the price continued moving in a steep upward trend.
There are two main things you need to do when trading a pro gap. First, you need to understand the reason why the gap has happened. You can do this by looking at all the relevant news. Second, you should look at the volume for confirmation on whether it is a pro gap or a novice gap. As shown in the chart above, a rise in volume was a good confirmation that there was more demand for the stock.
A novice gap is relatively similar to a pro gap. The only difference is that the asset fills the gap within a few hours or even minutes.
A novice gap happens when there is major news affecting an asset. After the news breaks, investors pile into the asset leading to more immediate demand. After a while, most traders move out, leading to a sharp reversal of the price. That means that the crowd overreacted news, and quotes are now leading to its fair price.
In case of a down gap, a sudden event can lead to a sharp decline in stock and an immediate reversal. This reversal is often known as filling the gap.
A good example of a novice gap is in the Goldman Sachs chart shown below. As you can see, the share price was in an uptrend when it had a down gap under high volume. Within a few days, the gap was filled, and the stock had a bullish reversal pattern.
There are several reasons why these novice gaps happen. First, when major news breaks, investors tend to panic and overreact, leading to a gap. The gap is filled when investors realize that the action was an overreaction. Second, a reversal happens because of the “buying the rumor and selling the news” phenomenon.
Like the pro gap, you need to look at the reason why the gap has happened and check out the volume.
An exhaustion gap happens when an asset is in a strong upward or downward trend. The gap sends a signal that this strong trend is nearing its end. It is usually identified by a high volume and a strong price difference between the closing and the opening price.
While an exhaustion gap is easy to identify, it can be easily confused with a runaway gap. A runaway gap is a continuation space that happens when the price is in a strong uptrend or downtrend. You can see those gaps in the Goldman Sachs and Tesla charts shown above.
In an uptrend, an exhaustion gap happens when the demand of an asset increases, leading to euphoria. After the gap, some holders of the asset may decide to take profits, which leads to a reversal. An excellent example of the exhaustion gap – together with the runaway gaps – is shown below.
Gaps happen in the market all the time. For experienced traders, they usually form the best opportunity to make money because a continuation or a reversal often accompanies them. The key to avoiding mistakes when trading gaps is to look at the volume and to wait and see how the pattern forms. In addition, it is always advisable to incorporate fundamental and technical analysis when trading these gaps. For example, in fundamental analysis, understanding the reason why a certain gap has happened can help you predict how the asset will move.