Complete Guide to Gap Trading

Gap trading can sound amazing – high returns in a short period of time, accomplished using clear rules and conditions that seem to take the guesswork out of investing.  

More importantly, gap trading seems to offer a way to take advantage of the stock market’s natural volatility.  Gaps seem to occur all the time – just look at Gap Inc.’s recent 19% gap down.

But if you dig further, the topic can get really confusing, really quickly.  It can be a challenge to wade through the technical jargon, ambiguous vocabulary, and get-rich-quick schemes that litter the internet with promises of becoming a millionaire while working two hours a day.

Never fear – in this article, we’re covering the basics of what a gap is, why they occur, and how traders can potentially benefit from using them to inform their stock trades.  We’ll cover real life examples and highlight some easy and potentially beneficial strategies that gap traders employ.

Whether you are looking to start gap trading or simply interested in a more focused approach to active investing, gap trading can offer interesting insights and systems to help us become more deliberate investors.

What is a Gap in Stock Trading? 📚

A gap is an area on a price chart where a share’s price has moved sharply up or down with no trading activity in between. Because the stock market can be volatile, gaps occur regularly, typically appearing after markets have been closed.

A gap occurs when a stock opens at a price that is different to what it closed with the previous day, reflecting an unexpected change in price overnight. Just as prices can go up and down, gaps can either be a “gap up,” meaning that the price has increased, or a “gap down,” where the price has fallen.

Although gaps tend to occur when markets are closed, they are possible during the regular trading day. Those intraday gaps typically develop because of a discrepancy between the number of buyers and the number of sellers, which create the conditions for a gap to occur.  That said, intraday gaps are far less common than gaps that develop overnight or over the weekend, particularly for certain types of assets, like Forex.

On a price chart, a stock’s daily price range is frequently shown by a graphical figure referred to as a candlestick. The body of the candlestick shows the day’s opening and closing prices for the share, while the “shadow” at either end shows the highest and lowest prices that the stock sold for during the course of the day.

When looking at a daily price chart, we can sometimes find a place where two consecutive candlesticks don’t line up – this is where a gap has occurred.  

So what exactly causes a gap? Typically, a gap occurs because of an outside catalyst – an earnings report, new senior executive appointment, upgrades or downgrades in ratings, or a news item that affects a company’s prospects.  Because these catalysts tend to occur when the stock market is closed for the day, it results in gaps appearing once markets reopen.

The Meaning of a Filled Gap 👨‍🏫

Interested gap traders will frequently run into discussions of “filled” gaps, causing confusion for newer traders.  A gap becomes “filled” when its price returns to the original, pre-gap level. For example, imagine a stock was trading at $32 per share before an overnight gap down occurred, dropping the price down to $27 per share.  

After a few weeks, the stock’s price recovers and begins trading at $32 per share again.  Once the stock hits that $32 per share mark, the gap has officially been filled.

Gaps can become filled for several reasons.  Many gaps are filled by price correction, where investors have over or undervalued a stock before the market moves to “correct” that overvaluation.

Another important reason why a filled gap may occur is due to the concepts of support and resistance.  Support is defined as the point where a downtrend in the price of a stock will stop, because the price point is now low enough that increased demand for the stock at that price keeps it from falling any lower.  For example, investors may think that $20 per share is too high for Zima stock, but at $2 per share, enough of them will purchase the stock to keep the price from sinking any lower.

Resistance functions the same way, albeit at the opposite end of the spectrum.  As the price of stock increases, the number of buyers willing to purchase it dwindles, until the price reaches a point where it can’t continue increasing due to the lack of interested buyers.

Understanding how support and resistance can help us predict when or if a gap will fill.  It’s also important to understand because gaps can increase the volatility of support and resistance levels.

Fading the Gap 💨

When a gap is filled during the same trading day that it occurs, this is referred to as “fading the gap.” For example, a company announced great quarterly earnings and their stock gaps up at the start of the trading day.  

As investors and analysts have more time to review the financial materials, they begin to notice some weaknesses, so around midday they begin to sell the stock.  By 2PM in this scenario, the shares have dropped back into the same price range that they were trading at the previous day and the gap has “faded.”

So, What Exactly is Gap Trading? 📘

Gap trading is a series of strategies used to buy and short stocks and other assets based on gaps in their trading charts.  To gap trade, investors typically identify gaps between opening and closing prices.  Once a gap has been discovered, traders then try to classify what kind of gap it is, so that they can devise an appropriate trading strategy.

At the core of gap trading is price volatility.  As gap traders, the most effective stocks for us to trade are those that have dramatic price fluctuations, since those fluctuations represent our opportunities to make a profit.  As a result, many gap traders tend to look into particularly volatile sectors of the market – industries like oil and gas, pharmaceuticals, and retail. 

Importantly, adverse economic conditions or national recessions tend to make these sectors particularly volatile, so they might be a good option if a bearish market is suppressing other trading opportunities.

Gap trading can create opportunities for long positions, where a trader believes that the price will continue to increase, allowing them to sell their shares for a profit at a later date.  It can also create opportunities for traders to take short positions, where a trader sells shares of a stock they don’t currently possess, in anticipation of the price decreasing and being able to purchase those shares at a lower price point later.

Likewise, the time that gap traders hold their stocks can be as individual as the traders holding them. Many day traders will utilize gap trading in an attempt to shorten their work day, trading to earn their daily profit during the first few hours of the trading day.  Alternatively, longer-term traders can use gaps to help them assess where the price of a stock is heading in the future, allowing them to purchase and hold a stock until the right moment to sell occurs.

Full and Partial Gap Analysis 🧮

When discussing gaps in the stock market, there are two sizes of gaps that occur: partial gaps and full gaps. Determining what gap size we are looking at is important, since it represents different degrees of change in the market’s sentiment towards a particular stock.

A partial gap occurs when a share’s opening price is higher or lower than the previous day’s closing price, yet is still within the price range of the previous day.  For example, let’s say that on the last trading day,  Tesla stocks traded between $870 to $950 per share and closed at $910. If the stock opens at $880, then Tesla’s stock has opened with a partial gap down, since $880 is still within the previous day’s trading range, but lower than the closing price.  

A full gap occurs when a share’s opening price is higher or lower than the previous day’s closing price and is outside of the price range of the previous trading day.  Going back to our Tesla example, if the previous day’s prices ranged from $870 to $950 and Tesla shares opened at $820, this would mean that Tesla had opened with a full gap down, since that opening price is outside of the previous trading day’s price range.

It is important to know whether a stock has experienced a full or partial gap, since they reflect different levels of market sentiment.  A full gap demonstrates that the market has been particularly volatile and that the demand for a particular stock has changed significantly.

Different Types of Gaps and How to Trade Them 🗃

Once we have identified a gap in a particular stock, it is critical that we try to classify what sort of gap it is.  To identify what type of gap we are dealing with, we will typically examine both the external motivations for the gap as well as the trading volume accompanying it.  

By looking at these two factors, we will be able to make an educated guess on what sort of gap we are working with.  This determination is critical, since our trading strategy will change depending on what sort of gap exists.

In this section, we’ll talk about the four types of gaps that occur, how to identify them, and what sorts of strategies traders use to best capitalize on these different gap types.

Common Gap ☑

The gap that traders are most likely to see is called a “common gap.”  These price gaps are typically independent of any specific price pattern or major event and don’t usually provide any exciting trading opportunities.  Sometimes referred to as “area gaps” or “trading gaps,” common gaps are generally filled relatively quickly – usually within a few days of occurring.

A trader can identify a common gap by looking for an external catalyst and at the trading volume.  For a common gap, there typically won’t be any sort of external event that is triggering the change in price.  For example, if a stock experiences a gap up after announcing a new CEO, then it isn’t a common gap, since we can easily identify the cause of the changing market sentiment.

Trading volume can also be a valuable clue in identifying a common gap.  Common gaps are typically accompanied by an average trading volume, rather than the increased trading volume that one might see with a different type of gap.

Because common gaps don’t have a clear technical reason or catalyst for developing and aren’t accompanied by high trading volumes, they don’t tend to provide any real insight into a stock.  This means that there isn’t an optimal trading strategy to utilize with them and many gap traders tend to avoid taking a position on these sorts of gaps.

Breakaway Gap ☑

A breakaway gap occurs when a share “breaks away” from a well-established trading range.  If a stock gaps up, then it breaks through its previously established resistance level, while a gap down breaks through its established support level.  As we discussed earlier, support functions as essentially a price floor, while resistance is typically the upper bound of a share’s recent pricing.

As we can see in this example, a breakaway gap signals the start of a new price trend – this stock had been trending downward, but after a sizable gap up, it began on an upward pricing trajectory.  This change in a stock’s pricing patterns or trends is what makes breakaway gaps so exciting for gap traders. 

As with other types of gaps, identifying a breakaway gap involves looking for a catalyst and examining the trading volume.  Once a potential catalyst has been uncovered, we can begin to examine trading volume – this is a critical factor, because breakaway gaps typically come with a sharp rise in trading volume.

For a breakaway gap up, a trader might take a long position on the stock, purchasing shares in hopes of being able to sell them at a profit at a later date.  For a breakaway gap down, a trader might take a short position, anticipating that they will be able to purchase their committed shares at a later date for a lower price.

The good news for interested gap traders is that breakaway gaps don’t typically fill quickly.  This means that we can give ourselves a little more time to fully do our research and make sure that we have properly identified the start of a new price movement before we commit our resources to the stock.

Runway Gap ☑

A runaway gap, which is also known as a continuation gap, shows an acceleration of an existing price pattern.  As shown in our example below, a runaway gap in a stock that already had an upward or bullish price trajectory appears as a gap up, continuing an upward price trend.

Runaway gaps are typically driven by intense investor interest – for example, a stock is already doing well and trending upwards, when a positive news story causes the stock’s price to push up even further overnight.  These gaps are typically changes of 5% or more, so the size of the gap can help a trader determine if they are looking at a runaway gap or a different type of gap.

Further, many market theorists have speculated that runaway gaps tend to follow breakaway gaps, so if an investor is still not sure that they’ve correctly identified a runaway gap, looking for a breakaway gap in that stock’s past may be useful. 

If a runaway gap is moving upwards, interested traders may want to place a stop just below the gap, meaning that they’ve placed a stock order to purchase shares of the stock at what they believe will be the lowest price that the market will continue to allow for. If a runaway gap is on a downward trajectory, a trader might place a stop just above the gap, meaning that they sell their existing shares or take a short position at the highest price point that they believe the market will bear.

These types of gaps don’t frequently develop, so gap traders should be aware that this is a relatively rare occurrence.  Luckily, runaway gaps typically take a longer period of time to fill, so interested traders have more time to make a decision on how they want to trade on this type of gap.

Exhaustion Gap ☑

Unlike a runaway gap, an exhaustion gap occurs when a price makes a final gap within the trend direction before reversing course. Exhaustion gaps typically occur when a stock is overbought, meaning a large volume of investors have purchased the stock and its price is now higher than its actual worth. This type of gap implies that an upwards trend may be about to end.

As we can see in the chart above, identifying an exhaustion gap requires looking at both the pre-existing price trends for the stock, as well as the overall trading volume.  First, we should ask ourselves if the stock has been on an upward trend ahead of this gap. Using the chart above, we can see that our stock had been experiencing an overall increase before the gap.

Second, we need to examine the volumes of trades that have been occurring, as an exhaustion gap typically occurs when buyers have stopped buying the stock in large quantities.  As we can see in our chart above, the gap was preceded by several days of low trading volume and was dominated by sellers, suggesting that there are not many interested buyers for the stock at this price point.

With an exhaustion gap, some traders may try to employ a contrarian position to the prior trend – shorting the stock in anticipation of the price beginning to fall.  While this strategy can prove profitable, it can also be extremely risky since we don’t know exactly when a stock’s price will begin falling.

Gap and Go ☑

While gap trading overall is practiced by both short and longer-term traders, gap and go is a specific type of day trading strategy that looks to capitalize on the wave of a high gapping stock.  Gap and go traders typically find their gaps during the premarket hours, by using either a stock market scanner or a real-time service that identifies gaps that will appear when the market opens.

Typically, gap and go traders look for stocks that are gapping at least 4% higher than the previous day’s close, with a high volume of trades.  Traders will also examine a particular stock’s float, or the number of shares that are available to trade.  Stocks with a low float or a low number of shares available, are more likely to continue to rise in price when the market opens.

Gap and go traders will make a series of quick trades during the pre market and early hours of the trading days, selling their shares during regular trading hours as the price begins to lose momentum.  For beginners, this strategy can be appealing because of its simplicity.  However, we should ignore the plethora of online hype about using gap and go trading strategies as a get rich quick scheme or as a way to design a “two hour workday.”

Interested traders should make sure to do their research and always try to find a catalyst for a particular stock’s price movement.  Without a clear external factor driving the change in price, it can be extremely risky to bet on a stock’s continued increase in price.

Equally importantly, gap and go traders should be sure to use stop-loss order on their trades to reduce their level of risk.  In a flurry of trading activity, a trader’s orders might not get filled at the price a trader intended and this can lead to less profit or even losses if we aren’t careful.

Finding Gap Up Stocks 🕵️‍♂️

A gap up occurs when the opening price for a stock is higher than the previous day’s close.  This reflects a rally in price and could be either an anomaly or the start of a new trend. Stocks that gap up can provide good trading opportunities for short or long-term traders, so they can be a good phenomena to examine as a beginner gap trader.

To find gap up stocks, many investors will use stock scanners or other tools provided by their brokerages.  These tools will scan the stock market extremely quickly and identify any stock matching the user’s inputted criteria.  A gap trader might set a scanner to identify stocks with an opening gap or even stocks that have opening gaps and then continue to trade higher.

Although these tools can perform a huge amount of heavy lifting for interested gap traders, they don’t fully eliminate the need for further research on the part of the trader.  Instead, these tools can help us to narrow our list of stocks that we are interested in, so that we can spend our time handling the research, rather than trying to find gaps amongst the thousands of stocks available to trade.

Identifying Gap Down Stocks 🔍

On the opposite end from a gap up, a gap down occurs when the opening price for a stock is lower than the previous day’s closing price. This means that there has been a decline in price, marking either the start of a new trend or simply a market blip that doesn’t necessarily convey more information about a stock.

For example, let’s imagine that after a steady upward trajectory, a stock opens with a 7% gap down from the previous day’s closing price.  After researching a potential cause for the price drop, we discover that the company’s founder is diminishing his role to pursue other ventures.  As gap traders, we have to ask ourselves –  is this gap down indicative of a new trend?  How might we best protect our assets while investigating if this gap is a true market indicator?

Just like with gap up stocks, many investors use stock scanners or other real-time tools to identify gap down stocks.  While either a stock scanner or manually combing through stock charts can help traders find a gap down stock, some background in short selling may be helpful before beginning to trade stocks on a downward trajectory.  For this reason, beginner gap traders tend to focus on gap up stocks.

Example of Gap Trading 📝

For a real-life example of gap trading, let’s examine the April 2022 stock prices of the retail giant, Gap Inc. (GPS).  On April 20th, Gap’s stock closed at $14.29, only to open at $11.55 on April 21st – a  whopping 19% gap down overnight.  

Now that we’ve identified a large and promising gap to work with, we need to attempt to identify what sort of gap it is.  First, we look for external catalysts and quickly find a few reasons why the market is feeling bearish on Gap. The day before Gap’s stocks plunged, the company announced both the resignation of Nancy Green, the CEO of the Old Navy division, and slashed their quarterly sales outlook.

Given the clear external reasons for the stock’s price slump, we can assume that the GPS gap down is not a common gap.  But is it a breakaway, runaway or exhaustion gap?  As investors, we can look at the price patterns of Gap’s shares over the past few months and eliminate some other possibilities.  

As we can see in the chart above, GPS shares have been on an upward trajectory since their April gap, a departure from their previously established downward price pattern.  This means that we can eliminate a runaway gap as a possibility, since Gap’s latest price trajectory isn’t in line with its previous trend.

As for an exhaustion gap, we can eliminate this possibility because our research shows us that Gap hasn’t been a highly traded or particularly hyped stock ahead of its sudden collapse in price.  Exhaustion gaps tend to appear at the ends of long upward price trends and Gap’s previously negative price trend means that this explanation simply doesn’t fit.

Eliminating all other possibilities, we can infer that Gap Inc.’s April gap down was a breakaway gap, meaning that it is likely the start of a new price pattern and has established new levels of support and resistance.

Pros and Cons of Gap Trading ⚖

Like all forms of trading, gap trading comes with plenty of benefits and drawbacks.  The single most important factor with gap trading is one’s own ability to interpret what sort of gap is present.  On the one hand, this is great news because it means that we already have all of the tools that we need – ourselves and our ability to do research.  

But on the flip side, when we try to identify a gap from a stock chart, we simply aren’t always correct.  Searching for gapping stocks can lead to a lot of false positives, so gap traders must constantly ask themselves if the gap they are identifying is a real market signal or merely an anomaly.  This challenge is particularly acute for new investors, who may struggle to identify profitable gaps or take full advantage of them.

This examination is especially important because of how much underlying research goes into gap trading.  Traders spend a large amount of time researching specific stocks, their external catalysts, and how these circumstances could impact the stock’s price.  But all of that research and data can make a trader feel as though a certain course of action is a sure bet – in reality, every trade comes with underlying risk.

Gap trading can also be a challenge because it requires contending with irrational exuberance on the part of fellow investors. Irrational exuberance refers to a psychological aspect of trading, where enthusiastic investors can drive up the price of an asset higher than its core fundamentals support.

Sometimes, irrational exuberance can create trading opportunities for the right gap trader, but it can also distort the market. Some overhyped stocks rise to incredible heights before they have a painful price correction.  Think of a company like Gamestop, whose passionate investors drove the company’s shares past the $300 mark based on little more than their own excitement and emotional connection to the brand.

Key Things to Consider Before Gap Trading 🔑

Before embarking on gap trading, interested investors should ask themselves a couple of questions.  First, we should consider what type of gap trader we’d like to be.  Are we interested in day trading, potentially using a short-term gap trading strategy like Gap and Go?  Or are we looking for longer-term trading opportunities?

It is important to understand how to choose a good stock broker that aligns with the type of trading we are interested in pursuing.  Gap trading is a form of active trading, so it’s worth examining what types of fees our current brokerage charges for trades, since these fees can quickly cut into our profit margins.

Second, when are we looking to perform our trades?  For a shorter-term gap trader, paying attention to what the stock market is doing in the premarket and after-hours periods is critical.  But, gap trading during these time slots comes with increased risk, in part due to the low volume of trades occurring and low liquidity due to the markets being closed.  For an investor looking to hold their stocks for a longer period of time, those early mornings, late nights, and increased risk might not be as important.

Third, what assets are we looking to trade using gap trading strategies?  Are we particularly interested in stocks from a certain industry?  Or are government securities or Forex our passion?  Successful gap traders spend an incredible amount of time researching and learning about the assets they wish to trade, so it makes sense that we would select a type of asset that we find interesting and are willing to learn more about.

Lastly, what sorts of tools are we interested in using?  Is a stock scanner a useful tool for our purposes?  If we are looking to make trades daily, then automating part of our process may be a necessary step.  But if we are more interested in longer-term trades, then we might be able to save ourselves some money and undertake our gap research manually. There are also a number of highly reliable stock analysis tools we can look into using as well.

Conclusion 🏁

In summary, gap trading can be a potentially profitable and exciting way to trade stocks for either short or longer-term profits.  For certain types of investors, the systems employed and the research required can be an interesting and fun way to invest in financial markets.  But it is important that investors begin gap trading with a clear vision of their goals and with a clear sense of what types of gap trading they’d like to pursue. 

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