The Gap Primer
| Gaps are shock events that jolt price up or down and leave an
"open window" to the last bar. Market folklore (such as the
infamous "gaps get filled") seems to offer guidance, but in
reality it has little value. After all, many gaps never get
filled. So how can we use these one-bar wonders to make good
trades and increase profits? |
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The first thing to do is figure out what kind of gap you're
dealing with. It should fall into one of these three categories:
- Breakaway gaps appear as markets break out into new trends, up
or down.
- Continuation gaps print about halfway through trends, when
enthusiasm or fear overpowers reason.
- Exhaustion gaps burn out trends with one last surge of
emotion. |
| Certain trades work best with each gap type, so proper
identification is extremely important. Use relative location and
key characteristics to place them into the right category. There
is also a psychological aspect to recognizing the correct gap.
Breakaway gaps "surprise" because they appear suddenly on charts
you've ignored. Continuation gaps "frustrate" because they pop
up where you think price should reverse. Exhaustion gaps
"relieve" because they print after you hold on for too long.
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Trade the trend on the first pullback to a breakaway or
continuation gap. In other words, buy the decline after a rally,
or sell the rally after a decline. The odds favor a reversal
back in the primary direction, even if these gaps fill. However,
the pullback trade often requires great patience. Markets retest
breakout gaps right after they occur, but many bars can pass
before price returns to test a continuation gap.
Use the continuation gap to target major reversals. The first
test usually occurs after closure of the exhaustion gap. But you
can't trade it if you can't find it, so here's a trick: Wait
until you can count three price moves, up or down. Then place a
Fibonacci grid across the entire trend and look for a
continuation gap at the 50% level. If you find one, place a
limit order within the gap and wait for a test to occur. The
retracement should provide enough support or resistance to force
a reversal. Once the gap is filled, place a trailing stop and
keep it close behind current price action.
Modern markets fill many continuation gaps for a bar or two
before they reverse. If you're a defensive trader, place your
order within this extreme price level. Many times you won't get
filled, but you'll save yourself whipsaws from entering too
early. Keep in mind the filled gap presents low risk only when
volume remains flat and price doesn't gap back through the old
gap to get there.
Exhaustion gaps print blowoffs that end a trend. This last
burst of energy can occur on high volume, but the lack of it
doesn't change the outcome. Exhaustion gaps fill easily, with
price often heading lower in a hurry. After this reversal, use
multiple time frame analysis to plan your next move. For
example, an exhaustion gap may also print a continuation gap in
the next larger time frame. Be patient if this sounds confusing.
Seeing this three-dimensional landscape requires a sharp eye and
a lot of charting experience.
