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Gap trading is a common stock trading term, referring to a strategy that aims to take advantage of the price difference, or gap, between the last closing price of a financial asset and the next opening price. This helps investors capitalize on potential short-term fluctuations in the market. This is how gapping stocks may benefit your portfolio and investment strategy.
Work with a financial advisor who can help you make smart investment decisions for your financial goals.
How Gapping Works
Gapping stocks is when investors purchase stock to benefit from the significant price differences that typically occur between the last closing price of a trading day and the opening price the next trading day.
Gaps can be caused by various factors, including news announcements, earnings reports and geopolitical events, among others.
Traders analyze gaps as part of technical analysis to understand market trends. A gap in pricing can signal important directional changes that provide investors with valuable insight. Aside from short-term price movements, a gap can also reveal shifts in market sentiment that create potential trading opportunities.
What Is Gap Trading?
Gap trading is a strategy traders use to capitalize on gaps in stock prices. This concept is fundamental because gaps can signal strong bullish or bearish sentiment.
A trader could buy a stock if it gaps up at the open and sell it if it gaps down. For example, if a company releases positive news after market hours, this might result in a gap up, prompting traders to buy the stock with the expectation of a continual rise.
On the other hand, a disappointing post-market earnings report could cause a gap down. This provides traders an opportunity to short-sell the stock so they can profit from the falling price.
It’s important to note that trading gaps can be associated with increased volatility, as they can present both opportunities and risks for investors. Some traders use gap trading strategies, while others approach gaps with caution, considering them as potential areas of price acceleration or reversal.
As with any trading strategy, be sure to conduct thorough research and risk analysis before making a trading decision based on gapping patterns.
Understanding Gaps
A trading gap is commonly represented as a price range on a chart where no trading activity has taken place. This usually happens due to significant events or news related to the company or the overall market.
Gaps can be categorized into full gaps and partial gaps.
Full gaps
A full gap happens when the opening price of a stock significantly deviates from the previous day’s high or low price. This largely occurs following major news events or economic announcements affecting the stock market. A full gap, for example, can indicate strong buyer enthusiasm and a potential upward trend, which can create a buying opportunity. Conversely, a full gap down might suggest heavy selling pressure, indicating a potential downward trend and an opportunity to short-sell the stock.
Partial gaps
A partial gap happens when the opening price is within the previous day’s price range, indicating less impactful news or minor sentiment changes in the market.
Nevertheless, a partial gap can also affect trading decisions. A partial gap down may represent a potential short-sell opportunity, where a trader could profit from a decline in stock prices. Conversely, a partial gap-up might signal a buying opportunity, assuming the price will continue to rise.
How to Find Gapping Stocks
Finding gapping stocks can involve a variety of online tools. These allow traders to filter stocks based on price gaps that typically happen outside of market opening and closing hours. Even financial advisors use these tools to help you pick the best stocks based on your portfolio.
When searching for a gapping stock, it’s important to note that there are three types of gaps to consider when deciding your investment strategy.
- Upward gap (positive gap). This occurs when the opening price is higher than the previous day’s high.
- Downward gap (negative gap). This occurs when the opening price is lower than the previous day’s low.
- Exhaustion gap. This type of gap usually occurs near the end of a trend and may signal a potential reversal. An exhaustion gap can be an upward or downward gap.
The best type of gap for your portfolio largely depends on your financial situation and investment goals. However, make sure you understand the reason behind the stock price change is happening so you can determine the likelihood of an eventual reversal.
If a stock price reverts to its previous position before the gap but still continues to increase, this could indicate a strong bullish status. Traders may interpret this as a signal to continue holding or even adding to their positions.
Types of Gap Trading Strategies
Once you identify a stock with a gap, the next step is deciding how to trade it.
The right gap trading strategy for you ultimately depends on several factors. Research considerations like market conditions and gap, as well as the underlying news driving the move.
There are several popular types of gap trading strategies.
1. Gap-and-Go Strategy
This approach is when investors immediately buy a stock after a strong upward gap – especially if it’s supported by high pre-market or opening volume. Traders using this strategy expect the momentum to continue throughout the day.
This strategy works best in strong bull markets or when positive news has clear long-term implications.
2. Fade the Gap
The opposite of the gap-and-go, fading the gap means taking a position against the initial gap direction. For example, if a stock gaps up significantly without strong fundamentals to support it, a trader may short the stock, anticipating a pullback to more sustainable levels.
3. Gap Fill Strategy
Historically, many price gaps tend to fill, meaning the stock eventually trades back to the pre-gap price level. This happens when the initial market reaction is overdone and prices normalize.
Gap fill traders look for signs that momentum is slowing before entering a position in the opposite direction of the gap.
4. Breakaway Gaps
A breakaway gap occurs when the price moves sharply out of a consolidation pattern or trading range, often on significant news. Traders may enter positions in the direction of the breakout, expecting a new sustained trend to develop. Breakaway gaps are generally accompanied by strong volume, which can help confirm the move.
When using any of these strategies, it’s essential to confirm the trade setup with additional technical indicators. Be sure to apply strict risk management rules to protect against unexpected reversals.
Bottom Line
Gap trading is a widely used investment strategy, profiting from the gaps in stock prices. Understanding full and partial gaps, as well as effective strategies to fill the gaps, can unlock significant profit opportunities. While gapping is an important market event, it also carries significant risks, underscoring the need for proper risk management strategies during gap trading.
A financial advisor can help you understand how your portfolio can benefit from sudden shifts in the market.
Tips for Investing
- Investing in a long-term plan can be difficult, with many factors to consider. An experienced financial advisor can weed through the potential pitfalls and help you reach your long-term goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- You may want to use a free investment calculator to estimate how your investment dollars can grow over time.
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