Even beginners know that a price trend is not a straight and stable line, but a graph of ups and downs. But there is one thing that often confuses novice traders. And these are gaps. At first glance, they seem to be just empty space that interrupts the price movement. However, their prevalence and impact on the market make them not only an important topic to study, but also a method for making money.

Understanding gaps and being able to interpret them is a valuable asset in the hands of astute traders. This article is dedicated to the topic of gaps, where ParadTrade reveals the nuances of their use to determine entry and exit points, as well as to optimize risk management.

What are gaps?

Within the framework of technical analysis, a gap (from the English gap) is a price gap on the chart of a trading instrument where there is no trading activity for a certain period of time. This visually displays price deviation from the expected trend or its continuation.

Gaps most often occur when there is a difference between the closing price and the opening price of the next day. However, they can also occur during a trading session.

How and why do gaps occur?

Gaps in the price chart, which most often occur at the opening of a new trading day, are explained by the arrival of new information during the period when trading is not taking place (over-the-counter time).

For a gap to form, this information must be perceived by traders as significantly positive or negative.

Sources of information may be different:

  • Political and economic events: geopolitical events, central bank decisions, macroeconomic indicators.
  • Natural disasters: earthquakes, floods, hurricanes.
  • Company news: earnings reports, new product or service announcements, management changes.

In this sense, a gap can be considered as a market reaction to news: negative information leads to the formation of a downward gap, and positive information, on the contrary, leads to the formation of an upward gap.

In addition to the information factor, gaps can occur in conditions of low liquidity and high market volatility. In such situations, a gap reflects a sharp imbalance between demand (buy orders) and supply (sell orders) for a specific instrument.

Types of gaps

Common gap. They represent price spikes on a chart that occur due to a lack of trading for a certain period of time. It is important to understand that common gaps do not usually signal the start of a new trend. They typically occur within a pre-existing trading range and have no long-term significance.

Breakaway gap. It means a price breakout occurs when the price suddenly moves beyond a previously established support or resistance level. This event can signal the start of a new trend and is often accompanied by significant trading volumes.

Runaway gap. Escaped gaps occur within the framework of an already formed trend, be it an upward or downward trend. Their main function is to confirm the strength of the current trend. A characteristic sign of an escaped gap is that its direction coincides with the direction of the trend. The psychology of a runaway gap is that traders who did not enter during the initial movement get tired of waiting for a correction and enter the market. This sudden interest in buying or selling occurs quickly, usually caused by unexpected news that forces the market maker to place orders at price points that are further away from the last traded price before the gap occurred.

Exhaustion gap. An exhaustion gap is a price gap that signals a possible end to the current trend (upward or downward). A fatigue gap shows that the current trend has reached its peak and can no longer continue. A gap is one of the best signals for traders because it alerts traders to the end of a trend and therefore the end of the current trend.

Examples of gaps in the market

Example 1. During the period from October 26 to October 27, 2023, a small upward gap formed in the shares of Company A. The share price jumped from $119.57 to $127.74. This gap became a harbinger of a reversal of the downward trend, and the stock price continued to rise in the following days.

Example 2. From October 24 to October 25, 2023, company B shares formed a downward gap. After several weeks of general price increases, the share price fell sharply from $138.81 to $125.61. Despite the fall, the gap didn’t lead to a continuation of the downward trend. Instead, the stock price resumed its rise and reached the level it was before the gap formed, thereby filling it.

Playing on gaps

Gap analytics is an integral part of technical analysis, helping traders understand the nuances of market behavior. The formation of a price gap can signal significant shifts in direction of movement, providing valuable information for investment decisions.

In addition to short-term price fluctuations, gaps can indicate changes in market sentiment and the formation of new trading opportunities.

Gap trading is a strategy based on capitalizing on price gaps that occur. This concept is fundamental because gaps can indicate strong bullish or bearish sentiment.

Traders can buy shares if the price opens with a gap up, and sell them if the price opens with a gap down. For example, a company publishing positive news after the market closes can lead to an upward gap at the opening of trading. This could prompt traders to buy shares in anticipation of further growth. Conversely, a disappointing earnings report released after the market close could cause a gap down. This creates an opportunity for traders to sell shares short, profiting from a decline in price.

It is important to note that not all traders actively use gap trading strategies. Some approach gaps with caution, viewing them as potential areas for price acceleration or reversal.

Gaps: opportunities for traders

Even though gaps are significant events in the market, trading them requires knowledge of techniques. Therefore, when trading gaps, it is necessary to use proper risk management techniques.

To receive individual recommendations on this topic, it is worth contacting a professional trader. Advice from an experienced professional will help you make the most of the opportunities arising from sudden changes in the market and profit from these changes.

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