Among the unusual things that may happen on the market on any given range is the gap. While gaps on a chart may seem intimidating and may look unusual, many experienced traders consider gaps a straightforward sign to gain profits. While this may be true, it actually takes a good amount of knowledge and experience trading with gaps to effectively make profits.
In this article, we’ll share with you how you can make potential profits out of gaps and how to implement it on actual trades on eToro. (profits are never guaranteed there is always the risk of losing capital aswell)
(NOTE: Before we continue, we have to give a disclaimer that the trading products offered by the companies listed on this website carry a high level of risk and can result in the loss of all your funds. CFDs are complicated instruments that are never guaranteed to provide you supplemental earnings. In fact, Around 68% of all retail investors experienced a loss while trading CFDs. Make sure to keep this in mind before attempting to use the eToro platform yourself. All the information found on this website is not official trading advice and all practices shown are referenced for the use of the Demo account only.)
What is a Gap in Trading?
Generally speaking, a gap in trading is that empty area or space on a chart where there is no activity. From a physical perspective, the price skipped that particular zone or area on the chart. Gaps usually happen on almost all charts at a minute range. Gaps can either be moving up or moving down and happen as the market opens.
Gaps can either be bullish or bearish and can signal different results. And depending on the analysis, a gap will always be filled – the price will go back to the gap area to fill that gap.
So, what’s the reason behind gaps? Basically, gaps form due to fundamental factors. These factors include product announcements or launches, upgrades as well as downgrades, the appointment of new directors or superiors, and many others. These disclosures are made public during off-trading hours but can also be made public during trading or near the closing of a trading day. On the next day, traders react to the disclosure, causing a gap in the chart – whether upward or downward depending on the effect of the disclosure or news.
Types of Gaps
Aside from the common types of gaps which include the gap up and gap down, there are 4 general types of gaps that depend on their location on a chart. These general types of gaps include the continuation gap, breakaway gap, common gap, and exhaustion gap.
Continuation gaps or “Runaway Gaps”, as its name suggests, signals a continuation of an existing trend. It usually forms when there is price acceleration from a bearish or bullish market. This gap is also the result of recent news or disclosure which further pushes the market to move on the same trend.
In the sample image, there is a strong acceleration of buyers as shown by the consecutive green candles before the gap. After the gap, the price moved up and dropped down momentarily but continued further with the bullish trend.
As a stop loss for bullish and bearish continuation gaps, the ideal stop loss point would be just below or above the gap. For a bullish continuation gap, the ideal stop loss point would be just below the gap. Whereas for a bearish continuation gap, the ideal stop loss would be just above the gap.
Breakaway gaps are somewhat similar to continuation gaps however only develop at a particular price pattern. Also, the gap serves as a confirmation for a breakout. When dealing with Breakaway gaps, it is important to identify the specific pattern along with its trend line. The breakout, as well as the gap, will occur on the trend line.
In the example below, the price tried to break the trend line twice but failed. However, it was successful in its third attempt which caused a bullish breakout or a gap up.
For Breakout gaps, it is important to always note the trend lines as these will serve as the base or top of a gap.
A Common gap as its name suggests is an ordinary gap within a chart that has no significant effect on an existing trend. These gaps can occur when the price is ranging or moving up and down. Common gaps have a much lesser area or space covered compared to the other three types of gaps.
The image below shows a series of Common Gap formations for AMZN. In this example, the gaps were not very significant in size as well as in effect. We can see that the gaps, the trend continued to move towards a trend that is hard to predict. in this example, the trend either continued or reversed as soon as the gaps formed.
With this example, we can say that Common gaps develop during consolidations.
Lastly, the opposite of Continuation Gaps is the Exhaustion Gaps. As the name suggests, Exhaustion Gaps signals a trend reversal or exhaustion of a current trend. This means if the market is currently bullish, the next expected trend after the gap is bearish. And if the market is currently bearish or going down, the next expected trend after the gap will be bullish.
This type of gap is usually caused by a huge number of traders who are going against the flow of the market. As a trend is accelerating, traders move the other way to counter the effect – for a bullish market with obvious buying acceleration, a huge number of traders will sell their shares to reverse the trend.
While dealing with these kinds of gaps can indeed be dangerous for a beginning trader, an experienced trader would definitely profit from this opportunity.
Our Final Say
Gaps can indeed be very intimidating to trade and given the different types, the market can either go bullish or bearish anytime. However, with the pointers and hints discussed in this article, you’ll be equipped with a good understanding of the type of gaps and how to make potential profits out of them.
In addition, gaps become easy to manage provided that their location on the chart is considered. Also, trend lines, as well as indicators like RSI, MACD, and volume, can become of great help in identifying entry and exit points in a gap.
If you want to practice working with gaps in a chart, you can check out the eToro virtual portfolio for a free practice account where you can trade on the actual market using virtual funds.
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