Gap Up and Gap Down strategy guideline (PDF)

Sometimes, we notice that the price of a particular share opens above or below the last closing price with little or no trading happening in between. Actually, this concept is known as “Gapping”. Hence, we can define a gap as the difference between the open price and the prior close price. However, it is essential for Forex and stock traders to understand gap trading and its specifics, as it represents a basic approach in the financial markets that can be turned into many profitable opportunities.

Gap Strategy guide

What is a gap in forex trading ?

In fact, a gap is an empty space on the trading chart where the price of a specific financial instrument makes a large jump up or down. with no trading activity taking place. In simple terms, gaps represent empty areas on the chart that happen when the price of an asset moves sharply. However, they emerge unexpectedly as the asset value changes significantly, due to multiple external reasons, such as fundamental or technical factors:
  • News announcements
  • Financial reports
  • Economic indicators
  • Supply & demand
A gap

Regardless, gap trading means that we should interpret and exploit these cases and turn them into opportunities. Besides, gaps can appear on the chart in different forms. Hence, we can classify them into 4 types, according to when they emerge in the price pattern and what signal they deliver.

Common gaps example

The common gaps represent the simple form of gaps. where the price moves sharply creating an empty area on the chart. Without delivering any useful indications or producing any trading opportunities. Hence, it reflects only the apparent lack of interest in the asset at that time.

Breakaway gaps example

Actually, the breakaway gaps are very similar to the breakout patterns. The only distinction is that they happen in the form of a gap. However, this type of gap frequently occurs in sideways markets (above resistance or below support) and at the end of patterns.

In effect, they provide a signal that a new trend is coming. Thus, we should take into consideration that the larger the breakaway gap, the stronger is the next trend will be. Generally, traders mark and associate the breakaway gaps with the earnings announcements.

Continuation gaps example

The continuation gaps or “the runaway gaps” represent a unique situation. Where suppliers and demanders (sellers and buyers) share the same sentiment about the price’s future direction. Usually, they appear in the middle of a price pattern and we can spot them either in an uptrend or in a downtrend.

Exhaustion gaps example

Same as the breakaway gaps, the exhaustion gaps appear near the end of a pattern or at an important S&R level. Yet, they signal the last try to reach the price highs or lows. Consequently, we will expect an upcoming reversal movement.

In order to clarify the different classifications of gaps, we consider the gaps chart example below.

Different classifications of gaps

In effect, we can’t talk about gaps without explaining the term “Filled gap“. So, as shown in the image above a filled gap signifies that the price moves back to the initial level before the gap happened (pre-gap level). Also, it is important to know that the exhaustion gaps are commonly the most likely to be filled because they signal the end of a tendency. Contrary to the breakaway gaps and the continuation gaps, who are used to ensure and confirm the current trend.

Financial markets can be very volatile and this may lead to recurrent gaps in the market. While gaps can happen moving up or moving down. Both still refer to the direction of the price movement on either side. Then let’s observe what the gap up and the gap down look like in trading charts.

What is a gap up pattern ?

In fact, a Gap up appears in the trading chart when an asset opens at a higher price than the last day’s close price. For instance, if the prior high price of a particular financial instrument was 1.1873. And the next day he opens at 1.1877, Then, a 4 points gap up. In other words, a gap up refers to a remarkable price jump from the price of close to a new price at the open. Further, if we notice that the gap is between two bullish candlesticks as the example below shows. Then, we should consider a bullish gap trade. Thus, it provides a good opportunity to buy or hold a long position.
Gap up

What is a gap Down pattern ?

A Gap down occurs when the opening price of a particular financial instrument is lower than the previous low price. For example, if an asset moves down sharply compared to the last day’s price (from 1057.50 to 1057.20). Then, a 30 points gap down. Additionally, if we notice that the gap is between two bearish candlesticks as shown below. then we should consider a bearish gap trade. Thus, it provides a good opportunity to sell or to hold a short position.
Gap down

how to trade gaps in forex market ?

The Forex market can be very volatile and this may lead to recurrent gaps in the market. However, gaping most commonly occurs on Monday, when a new trading session begins. Also, it can happen overnight or during daily trading hours when there is a rapid jump in the price of a currency.

Weekend price gaps

Trading weekend gaps is a very popular technique among Forex traders. It simply depends on entering a trade once the new week starts with the appearance of a gap. (using a weekly timeframe). These gaps emerge when a major event takes place on Saturday (the Forex market is closed). So, depending on the result of the event, there could be an important consequence (Gap up or gap down) for a currency pair when the market opens on Monday. Nevertheless, price gaps are fairly rare for some currencies. So, we are likely to catch gaps in a currency pair like the “EUR/USD” from time to time. So here’s an example of the weekend price gaps in the EURUSD.

Forex: EURUSD

Due to the French election, the EUR/USD currency pair marks an important gap that begins Monday 17 April 2017. As we see in the chart above, on 16/04/2017 the price closed at 1.07266. Then, it opens on 23/04/2017 at a higher price (1.09047). It’s a 178 points gap up.

Anyway, relying on such a gap trading technique requires us to know how to monitor our trading risk per trade to avoid any unfavorable potential effects.

How to trade gap stocks market?

Actually, while trading stocks we can face gaps quite often. Evidently, shares are less speculative than other financial instruments like currencies and commodities. Nevertheless, traders deal with gaps in the stock market by following a set of decisions. These decisions are built on movements that constantly repeat in the market:

  • A gap-up in an up tendency: It signals a good opportunity to open a buy order and maintain a long position.
  • A gap-down in a down tendency: It signals a good opportunity to open a sell order.
  • A gap-up during a downtrend: It signals a good opportunity to take a short position on the stock.
  • A gap-down during an uptrend: It signals a good opportunity to take a long position on the stock.

Consider the “TESLA” chart below, where we notice many gaps:

stocks: Tesla

How do you formulate a gap strategy?

Gap trading represents a straightforward and disciplined process for buying and selling financial instruments. However, there are multiple ways to take advantage of these gaps by following different gap trading strategies. Thus, in order to create a smart gap trading strategy, we can rely on some fundamental factors that favor gaps like financial events. For instance, a positive earnings reports announcement can signal an upcoming gap up on the following trading day. Hence, we can make profits by opening a long position (buy order). conversely, negative earnings reports deliver a sign about an upcoming gap down on the next trading day. Thereby, we should open a short position (sell order). This gap trading strategy is often used by traders as it can help them to anticipate but not guarantee what can happen in the future. On the other hand, some traders believe that when we observe a price gap in the market, it will get filled later. So they focus on how to fade those gaps in the opposite direction. In a way, they will fade a gap up by making short positions and fade a gap down by long positions.
Filled gap

Moreover, in an effort to ensure better risk management, we can calculate potential entry and exit points by relying on an easy gap trading strategy. Simply, we need to identify gaps between opening and closing prices on a trading chart. Where the price moves sharply and there are volatile actions. Then we will use this gap to develop an appropriate gap trading strategy by taking the height of the gap and projecting it to identify the possible target. As shown in the image below.

Continuation gap strategy

conclusion

Briefly, we can say that gaps are “a no price”. However, analyzing them can provide strong and significant signals in the financial markets. So, to guarantee a good gap trading experience, we can try to learn their types and follow the trigger of their appearance (like news, financial reports, etc…). Also, we can try some gap trading strategies as we mention in this lecture earlier.