Trading Price Gaps

[RichardCox 10]

For day traders, gap trading strategies are amongst the most favored market setups, with many profitable scenarios seen when the formation occurs. The downside is that these occurrences are relatively rare but can generally be seen when markets open as traders establish new positions based on information or news headlines that were released previously. When gapping signals do occur, experienced traders will look to capitalize on the intraday moves, as this is likely to be the source of the day’s volatility and trend direction.

 

4 Gapping Types

 

Full Up Gaps occur when prices open higher than the high of the previous session. Full Down Gaps occur when prices open lower than the previous days lowest price. Partial Up Gaps occur when prices open above the close of the previous session while Partial Down Gaps are seen when prices close below the low of the previous trading session. Generally speaking, bearish trading signals are generated when prices open higher, run out of momentum and then fall back below the previous session close. Bullish gapping signals are seen when prices open lower before reversing and rising above the previous session high.

 

These are contrarian events, however, while the majority of price gaps result in price continuation, as the impulsive move is based on macroeconomic data or news events that alter the market’s perception of an assets value. The four gap types will give trading signals for long and short positions but should only be triggered after markets are given the opportunity to establish clearly defined ranges. For intraday positions, this can be set at either a 30 minute or one hour interval. Establishing positions before ranges are defined can be undertaken but it should be understood that a higher level of risk will be associated with these trades.

 

Allowing for Increased Volatility

 

By definition, market conditions where gaps occur will also see enhanced volatility levels. Because of this, stop losses need to be managed aggressively once positions are established. The best way to manage this is to use trailing stops, that risk no more than 2 percent at any given moment. Since downside volatility generally is seen as being more forceful that upside volatility, stop losses for bear positions can be tighter than those seen in long positions.

 

Filling the Gap

 

Price activity, once prices have opened in a different area than what was seen during the close, must be monitored closely as reversals can be sharp and unexpected. Using the criteria above, it is relatively easy to spot when false breaks occur (i.e. a bearish signal after a bullish gap or a bullish signal after a bearish gap). But when momentum starts to slow after the initial impulsive move, there is a building probability that prices will “fill the gap” and return to their original level as all of the previously set buy and sell orders are filled.

 

Conclusion

 

Price gaps are generally instigated by major news events or significant macroeconomic data surprises that cause market participants to buy or sell an asset in excess. While these are fundamental events, these conditions are vital for technical traders as well because failure to see builds in momentum will likely lead to false breaks and sharp reversals. Momentum can actually build in the opposite direction when false breaks occur as late traders are stopped out in unexpected areas.

 

Short term traders should remain watchful of price gaps because these situations tend to be the impetus for long term trend reversals and these can be spotted by traders that are primarily technical in nature even though the original reaction was created by fundamental occurrences.