Gaps are a common market pattern and is a strategy used by both day and swing futures traders. In this article, we highlight the importance of being able to interpret gaps in the right market context and how to use them to form better trading decisions.
Introduction to Price Gaps
A gap is represented by an empty space between the close of a candlestick and the open of the next candlestick. On a chart, it looks like price jumped between the candle close and open, leaving empty space in between. Some markets are more prone to having gaps, such as futures and stock markets where they occur regularly whereas other markets such as Forex have much fewer gaps.
Do gaps always fill?
The most common trading strategy around gaps is trying to trade the gap fill – which means traders speculate that the empty space between the two candles will fill and price will move in a way to cover up the space. Yes, it is true that gaps are sometimes closed but speculating on a gap close is usually not a good trading strategy. As we will see later when we move on to the chart studies, there are certain gap types where price does not close the gap. Traders who rely on a gap close can easily run into losses if they can’t let go of a position where price doesn’t eventually close the gap. Risk management around these price levels is critical. Instead of trading the gap fill, gaps can be used in better ways to interpret and understand price movements in a bigger trading context.
The 4 Gap Types
The common gap, as the name implies, is a common price pattern and it usually does not provide meaningful information about the market where the gap occurs. The common gap is the gap type that tends to see a gap fill the most often. However, common gaps are usually small in size and typically don’t offer a reasonable reward to risk payout.
The breakaway gap is a gap type that usually does not get filled initially and price typically trades away from the breakaway gap immediately. A breakaway gap occurs when price gaps over a support or resistance level. It is like a regular breakout pattern, just that the actual breakout happens in the form of a gap.
A breakaway gap signals strong momentum and price usually keeps on trending after a breakaway gap. Furthermore, the larger the breakaway gap and the stronger the subsequent candle after the gap, the stronger the prevailing trend. The crude oil chart shows nicely how price gapped over the support level, leaving a large gap and then continuing its downtrend.
Runaway gaps often see the gap close but trading the gap fill on a runway gap has to be avoided at all costs because it’s a high-risk trade. A runaway gaps occurs during a strong trend where price keeps gapping into the direction of the trend. Typically, you will see multiple runaway gaps during a strong trend.
Instead of speculating in a countertrend gap fill during a runaway gap, traders can use this information to enter trend following trades or remain in their existing trades as a runaway gap signals strength.
Exhaustion gaps usually get filled, but potentially, the best way to trade an exhaustion gap is not to speculate on the relatively small gap fill, but use the information to time exits and entries around the pattern.
An exhaustion gap occurs at the end of a trend or at important support and resistance levels. The first gap in the direction of the trend can look like a runaway gap but the following candle is usually either a Doji pattern or a pinbar, showing the indecision or rejection of a price level. It is common to see a second gap into the opposite direction on an exhaustion gap pattern, confirming the reversal. In the example below, the exhaustion gap pattern looks like an “abandoned baby” reversal pattern.
As you can see, price gaps can offer a lot of information about market dynamics and about who is in control of a market. Instead of trying to squeeze out a few points, trading the riskier gap fill, a trader can use the information provided by a price gap to form a sophisticated trading idea and combine it with other trading concepts.
There is a substantial risk of loss in futures trading. Past performance is not indicative of future results.