Gap Trading
Gap trading is a strategy that takes advantage of price gaps on charts. A gap occurs when a security’s opening price is significantly above or below its previous day’s closing price, leaving a visible “gap” on the price chart with no trading activity in that price range. Gaps are often caused by news, earnings reports, or market sentiment changes overnight.
What Is a Gap?
A gap is an area on a price chart where no trading occurred. Gaps form when the opening price is dramatically different from the previous close:
– **Gap up**: opening price is above the previous close (bullish gap)
– **Gap down**: opening price is below the previous close (bearish gap)
Gaps are more common in individual stocks than in indices, because individual stocks are more susceptible to overnight news events.
Types of Gaps
**Common gap**: occurs frequently, often in range-bound markets. Usually fills quickly as price returns to the pre-gap level.
**Breakaway gap**: occurs when price gaps out of a consolidation or chart pattern on high volume. Signals the start of a new trend.
**Runaway (continuation) gap**: occurs in the middle of a strong trend, confirming the trend’s continuation.
**Exhaustion gap**: occurs near the end of a trend, signalling potential reversal. Usually fills quickly.
Gap Fill
Many gaps are “filled” when the price returns to the level before the gap. Gap fill traders bet that a gap will be filled by entering on the opposite side of the gap direction.
**Example**: If a stock gaps up from Rs 200 to Rs 215, a gap fill trader shorts near Rs 215, expecting the price to return to Rs 200.
Practical Example
Infosys reports strong quarterly earnings after market close. The next morning, it gaps up from Rs 1,750 to Rs 1,810. A breakaway gap trader, seeing high volume and the gap out of a 3-month consolidation, buys at Rs 1,815 on the open. Over the next 2 weeks, momentum continues and the stock reaches Rs 1,950 as analysts upgrade their price targets.
Key Takeaways
– A gap is an area on a price chart with no trades between the previous close and the new open
– Types include common, breakaway, runaway, and exhaustion gaps
– Breakaway gaps on high volume are powerful directional signals; exhaustion gaps often reverse quickly
– Gap fill is a counter-trend strategy betting that gaps will be filled (price returns to pre-gap level)
– Earnings-driven gaps are the most common form in Indian equity markets
