Gap trading is a very popular term amongst traders and many professional traders use gap trading for swift profits. It has gained popularity in the markets solely because of the fact that plenty of gaps are created on charts and when identified and traded correctly they bring quick profits.
But what exactly is a gap?
In simple terms, a gap is that area on the chart where no trade has occurred. In other words, there is a big difference between the price of the previous day’s close and the next day’s open. This is caused by a sudden interest that has developed in the instrument after the price closed for the day. This could be any positive or negative news related to that instrument causing the masses to place buy or sell orders after market hours.
Hence, when the market opens, the price zooms up causing a gap on the upside or it falls down drastically causing a gap on the downside.
Besides the opening gap there are three other kinds of gaps:
- Runaway gaps
- Breakaway gaps
- Exhaustion gaps
Runaway gaps usually occur in a strong trend and are considered bullish in an uptrend and bearish in a downtrend.
Breakaway gaps usually occur after long periods of consolidation and could result in a continuation of the trend or show a strong reversal.
Exhaustion gaps usually occur at the end of an existing trend as a sign that the same is about to end.
A gap may occur naturally or may be created by professionals. News about a particular instrument may cause a gap to occur naturally due to the exciting buying and selling sentiments of the investors. However professional buying is done to create gaps only to trap the novice and amateur traders.
Trading gaps requires a special skill set to identify and differentiate between a natural gap and a professional gap. It should only be attempted by traders after attaining a thorough understanding of the same.
Gap trading can, however, be extremely fruitful and result in very quick gains as a gap trader more often than not trades ahead of the crowd.