Trading the 4 Types of Price Gaps
Price gaps are a common occurrence in the markets these days. While there were quite rate in the forex markets, that changed over the past few years. Typically one gets to see gaps in the Forex markets on Monday’s open and at times, late into the U.S. trading session or in early Asian trading session. Trading gaps can offer a simple yet reliable way to trade. Gaps work on the principle that when there is a visible price difference between the previous session’s close and the current session’s open, it signals something to the markets.
Gaps occur due to strong buying or selling pressure. In such instances, prices jump at the next session’s open, leaving a gap. Gaps can be traded in many ways, but the closest resemblance is that gaps can be used as part of support and resistance trading as well. While gaps are easy to trade, one should remember that the price action can be swift which could lead to strong losses if not traded properly. However, for those who prefer to make quick gains, trading gaps can be a good way to day trade the markets. Gaps can occur as an up-gap or a down-gap and these can be broadly classified into the following four types of price gaps.
The 4 Types of Price Gaps
1. The Breakaway Gap
The breakaway gaps occur when price gaps higher or lower after trading in a range. When price gaps from the range, it can signal a strong move in the direction of the gap. The breakaway gap signifies that buyers or sellers eventually managed to overwhelm the range and eventually overpower the other side.
How is the Breakaway gap pattern formed?
A breakaway gap is formed around congestion or sideways markets. Usually, the more congested price is, the better the chances that a breakaway gap can be formed. To identify this gap, simply look for areas of consolidation in the price chart.
Figure 1 – Breakaway gap
How to Trade the Breakaway Gap?
In the above illustration you can see a breakaway gap in action. After a few sessions of consolidation, prices breakaway from the range and gaps lower. Trading this pattern requires some practice. In some cases, price seldom pulls back, but in the above example you can see how price retraced some part of the gap before pushing lower.
The best way to trade the breakaway gap is to wait for a retracement and when a local high is formed, you can then sell (or buy when a local low is formed in an up gap). The risk reward set up for such gaps depends on the trader itself.
2. The Runaway Gap
The Runaway Gap occurs as a result of increased interest in the market in question. These are also called as measuring gaps. Such gaps occur when the markets realize a bit late about the unfolding trend. A runaway gap typically occurs during the middle of a trend and can be used to signify trend continuation.
How is the Runaway Gap formed?
The runaway gap can be seen in the middle of a trend. Typically, in an uptrend you can find up gaps forming while in a downtrend, you can find down gaps forming. Such runaway gaps can signal that the price will continue moving in the same direction. However, pay attention to where the runaway gaps occur. Sometimes you might find that the runaway gap can occur late in the trend which can be disastrous as price can pose the risk of a strong reversal.
Figure 2 – Runaway gap
How to Trade the Runaway Gap?
The first step is to look for a trend that has been formed. In the above example (Figure 2) you can see the up gap that formed in the runaway gap. This comes after a strong uptrend previously. Combining the above information, long positions can be taken on the next session after the gap.
Stops can be placed at the pivot low below the gap with risk reward set to 2 or 3 times. Using other indicators such as moving averages or ADX to ascertain the trend can also help.
3. The Common Gap
The common gap or area gap can occur without any event backing the move. The main risk for such types of gaps is that they can be quickly filled. For example, price can gap higher in a common gap but this gap can be filled as price retraces back to the previous closing session which formed the gap.
How is the Common Gap formed?
The common gap is formed at regular intervals. These gaps can occur inside a range or even in a trend. The main differentiating factor is that common gaps tend to be filled almost immediately. Such gaps can be easy to identify and can signal a minor retracement before the previous trend resumes.
Figure 3 – Common Gap
How to Trade the Common Gap?
To trade the common gap successfully, simply wait for the gap to be filled. You can generally expect price to spike through or even close at the gap sometimes. Once the gap has been filled, you can take the position in the direction of the trend. Remember that a common gap simply shows a short term reversal. Therefore, in a downtrend, you can find an up gap which is the most common. Similarly, in an uptrend, you will find a down gap. Stops can be placed at the recent pivot high or low, above or below the common gap while profits can be booked based on the risk/reward ratio or other technical indicators.
4. The Exhaustion Gap
The exhaustion gap occurs at the top end of a rally or at the bottom end of a rally. Some common price action examples include island reversals where you can see prices gapping higher or lower before reversing direction. The exhaustion gap can be a good way to ascertain whether the trend in the market has exhausted and whether it is time for a correction or a pullback in prices.
How is the Exhaustion Gap Formed?
The exhaustion gap can be seen at the top or bottom in a trend. The exhaustion gap typically signals exhaustion to the trend. In some markets where true volume is found, you can see that the volume generally increases on these gaps. What follows the exhaustion gap is the reversal that takes place later. The reversal is in the opposite direction of the exhaustion gap. Thus the exhaustion gap can be viewed as an critical area during the reversals.
Figure 4 – The Exhaustion Gap
How to trade the exhaustion gap?
Once an exhaustion gap is identified, simply mark the gap. Of course, do not forget to see whether the gap occurred at the top of a rally or at the bottom of a downtrend. Once the gap has been identified, wait for price to break down below this gap or above the gap (following a downtrend). Stops can be placed at the pivot high or low above or below the gap and the profits can be booked based on a risk reward ratio set up or to the nearest support or resistance level.
Trading the 4 Types of Price Gaps
In conclusion, gaps are relatively easy to trade and can signal good market information and sentiment. With enough practice, traders will be able to easily identify the four types of price gap and trade accordingly. The most important when trading the 4 types of Price gaps is to maintain strict discipline and money management rule. If you can do this, then you will have a wonderful journey with Price Gaps. Good luck!
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