In order to use the gap strategy, you will have to discover gaps on your trading charts. A gap can appear as a consequence of different occurrences. There are different gap types, and not all can be traded the same way.
The common gap is a result of purely coincidental factors. They have no significance and you are advised to overlook them as a trader. Trends are neither produced nor stopped by common gaps.
The common gap frequently appears when there are very few traders who are actively operating in the market. This results in low liquidity, which again produces common gaps.
In order to identify the common gap you should keep your eyes on the trading volume. If the volume was low when the gap occurred, you are probably looking at a common gap produced purely by coincidence. A rule of thumb is that the higher the trading volume, the greater the probable significance of a gap. This means that assets that are rarely traded are not suited for a gap trading strategy because the volume will frequently be too low.
Should you discover a common gap, simply overlook it and persist with your technical analysis as if the gap didn’t exist at all.
Learn more about gap types under the table…
A breakaway gap most commonly appears when a major news event pertaining to an asset has occurred. The pre-existing market was defined either by a sideways movement of slow-moving trend. Then big news was announced and gave rise to a breakaway gap. This alters the chart completely, and will in most cases instigate a new trend.
An uptrend will probably occur as a result of an upwards breakaway gap, whereas as a downtrend is a more likely result of a downwards breakaway gap.
In order to recognize a breakaway gap, these are the signs to look out for:
Should the gap be greater in size than the value of the average true range, you can assume it is a breakaway gap. If the opposite is true, you ought to simply overlook it. Naturally, we are only offering a general piece of advice here. This is not a rule written in stone. None the less, you will need to ascertain that the gap you have found is in fact large enough to be a breakaway gap.
This gap type has a lot in common with breakout gaps. A Runaway gap is different in that it does not appear in slow market conditions, but during an ongoing trend. In the case of a runaway gap, major news will appear that verifies the ongoing trend. You should be aware, that like a breakout, a runaway gap can also cause an ensuing pullback.
None the less, they do offer confirmation for the ongoing trend. This information can be used by trend followers and swing traders alike as an indication that the trend remains strong.
An exhaustion gap can be thought of as the opposite of a runaway gap. When the market has slowed down after moving strongly in a direction for some time, this indicates that the occurrence that first caused the movement is no longer significant. An exhaustion gap is defined as a gap that appears in the direction of the previous movement in times of a low trading volume.
In most cases, such a gap will appear when the majority of traders are no longer investing in the movement continuing, whilst there are still a small number of traders who persist with actively buying and selling the asset in question.
The most convenient method for identifying gap types such as a runaway gap (which you should trade on), as opposed to an exhaustion gap (which you shouldn’t) is to focus on trading volume. It is a generally accepted principle in technical analysis that you should never trust movements that are caused by low trading volumes.