In addition, runaway gaps will act as support or resistance in future corrections and price moves. Measuring gaps (or runaway gaps) tend to occur around the middle section of a price move (such as a trend).
 

Exhaustion Gaps: This type of gaps occurs at the end of a significant price move. For example, in an uptrend price will lead forward in a last attempt to reach higher highs or lower lows (in a downtrend). Nevertheless, price quickly starts to move below the exhaustion gap. The confirmation for an exhaustion gap should be the close of a trading period below the gap.

Gaps as a Trading Opportunity

Gap trading as any other trading style such as trend following, price breakout trading, and price pattern based strategies involves a level of risk. Therefore, risk management and effective stop loss placing will be critical to succeed with gap trading opportunities.

Furthermore, the initial spike may have been fueled by overly optimistic or pessimistic expectations by the market participants, therefore, suggesting the possibility of a correction in the opposite direction.

Trading Considerations for Effective Gap Trading

There are certain guidelines that can be followed by traders to ensure trading gaps in the best possible manner and taking advantage of these types of trading opportunities:

Locating important support and resistance levels that could compromise the gap’s profitability: Finding conflicting support and resistance levels will permit to develop a better forecast of when price will retrace, which will allow the gap to be partially or completely filled.

Locating price patterns that have occurred before a gap: price patterns are utilized to classify gaps and will tell you the likeliness for a gap to be filled.

Adjust risk depending on the classification of the gap: there are three types of gaps and each one represents a different irregularity in price. Exhaustion gaps are normally the most likely to be filled as they appear at the end of a price move and a correction is expected. On the other hand, breakaway and runaway gaps are significantly less likely to be filled; therefore they represent more risk to the investor as they signal and confirm the direction of a current price move.

<<Previous     Next>>