The Gap
Primer
| Gaps are shock events that jolt price up or down and
leave an "open window" to the last bar. Market folklore
(such as the infamous "gaps get filled") seems to offer
guidance, but in reality it has little value. After all,
many gaps never get filled. So how can we use these
one-bar wonders to make good trades and increase
profits? |
|
| The first thing to do is figure out what kind of gap
you're dealing with. It should fall into one of these
three categories:
- Breakaway gaps appear as markets break out into new
trends, up or down.
- Continuation gaps print about halfway through trends,
when enthusiasm or fear overpowers reason.
- Exhaustion gaps burn out trends with one last surge of
emotion.
|
| Certain trades work best with each gap type, so
proper identification is extremely important. Use
relative location and key characteristics to place them
into the right category. There is also a psychological
aspect to recognizing the correct gap. Breakaway gaps
"surprise" because they appear suddenly on charts you've
ignored. Continuation gaps "frustrate" because they pop
up where you think price should reverse. Exhaustion gaps
"relieve" because they print after you hold on for too
long. |
Trade the trend on the first pullback to a breakaway or
continuation gap. In other words, buy the decline after
a rally, or sell the rally after a decline. The odds
favor a reversal back in the primary direction, even if
these gaps fill. However, the pullback trade often
requires great patience. Markets retest breakout gaps
right after they occur, but many bars can pass before
price returns to test a continuation gap.
Use the continuation gap to target major reversals.
The first test usually occurs after closure of the
exhaustion gap. But you can't trade it if you can't find
it, so here's a trick: Wait until you can count three
price moves, up or down. Then place a Fibonacci grid
across the entire trend and look for a continuation gap
at the 50% level. If you find one, place a limit order
within the gap and wait for a test to occur. The
retracement should provide enough support or resistance
to force a reversal. Once the gap is filled, place a
trailing stop and keep it close behind current price
action.
Modern markets fill many continuation gaps for a bar or
two before they reverse. If you're a defensive trader,
place your order within this extreme price level. Many
times you won't get filled, but you'll save yourself
whipsaws from entering too early. Keep in mind the
filled gap presents low risk only when volume remains
flat and price doesn't gap back through the old gap to
get there.
Exhaustion gaps print blowoffs that end a trend. This
last burst of energy can occur on high volume, but the
lack of it doesn't change the outcome. Exhaustion gaps
fill easily, with price often heading lower in a hurry.
After this reversal, use multiple time frame analysis to
plan your next move. For example, an exhaustion gap may
also print a continuation gap in the next larger time
frame. Be patient if this sounds confusing. Seeing this
three-dimensional landscape requires a sharp eye and a
lot of charting experience.
