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Have you heard of gap trading? It is where traders take advantage of the price differences in stocks happening during the market close. But do you know why these gaps occur? In a usual scenario, the stock prices remain unchanged when the market is closed. However, this is an exception.
In today’s article, let’s explore how these gaps occur, what they indicate and how to trade such gaps.
Gap up and gap down of stocks
A gap is when a stock’s opening price is different from the stock’s closing price on the previous day. Such changes in prices are a result of market events and news that break out when the market is closed. A news update about a stock can significantly impact the stock’s demand and supply, leading to a change in price.
Are you now wondering how the demand and supply can change when the market is closed? Well, that is because of after-hours trading. The NSE and BSE allow after-hours trading in India from 3:45 PM to 8:57 AM and 3:45 PM to 8:59 AM, respectively.
Now that we understand gaps and how they occur, let us learn the concepts of gap up and down.
- In a gap up, the opening price of a stock is higher than the previous day’s closing price.
- A gap down is where the stock opens the next day at a lower price than the previous day’s close price.
A gap-up suggests that the stock is bullish. It indicates that the news has triggered interest in buyers, and the demand for the stock is rising. Such stocks also show a potential for further growth. However, investors must analyse the strength of this uptrend before investing in such stocks.
A gap down is where the stock is bearish. The decrease in price from the previous day suggests that investors are pessimistic about the market, due to unfavourable news about the stock.
Types of gap ups and gap downs
The gaps in stock prices can be of four types:
- Full gap up – Next day’s opening price > Previous day’s price.
- Full gap down – Next day’s opening price < Previous day’s price.
- Partial gap up – Next day’s opening price > Previous day’s closing, but < Previous day’s highest price.
- Partial gap down – Next day’s opening price < Previous day’s closing, but > Previous day’s lowest price.
How do you predict a gap up and a gap down?
Predicting gaps helps investors take advantage of the changing trend. Such predictions serve as leading indicators for investors to strategise their trades without missing opportunities.
Keeping a tab on the news and analysing the stock’s reaction concerning price and volume is one way to predict the trend. Traders can also use technical indicators involving momentum, trend strength, averages, etc., to predict potential gaps.
However, traders must also ensure to adopt risk-mitigating techniques like stop loss, since the gaps and trends may be temporary.
Trading the gaps
To take advantage of gaps, traders must take positions in advance. However, it is quite challenging to do so, given the unexpected occurrence of such gaps.
The decision to take positions in the direction of the gap (long position in a gap up and short position in a gap down) or against the gap (long position in a gap down and short position in a gap up) depends on the sustainability of the gap.
Some gaps are temporary and are closed quickly, indicating a false price movement. Other genuine gaps may lead to price movement in the same direction, giving clarity about the trend to investors.
Bottomline
Gap trading is the process of trading to take advantage of changing prices when the market is closed. A gap occurs when there is a news update about a stock during off-trading hours. In a gap up, the opening stock price is higher than its previous close, and in a gap down, the opening stock price is lower than its previous close.
Identifying such gaps and formulating appropriate gap up and gap down strategies can help traders make high profits. Such gaps also act as early signals of potential change in market trends. Hence, understanding the causes and consequences of such gaps is essential for investors.
FAQs
A breakaway gap is a type of gap where the change in the stock’s price is significant with a sharp rise or fall. It typically indicates a substantial shift in market sentiment, often suggesting the start of a new trend. Traders often decipher breakaway gaps as powerful signals for future price movements.
An exhaustion gap is when the opening price differs from the previous day’s closing after a sustained trend. It typically indicates the exhaustion of the stock in following the same trend. Traders use this as a signal to interpret that the momentum is slowing and there may be a potential reversal.
A continuation gap is a gap that occurs in between a strong trend. The term suggests that the trend is strong enough to continue even after the gap. The gap is usually for a short period, suggesting a pause, post which the trend will again resume. It often occurs when the dominant set of traders have confusion in their approach and analysis of the market.
Yes, trading gaps can be profitable. The different types of gaps help traders with early signals of continuing trends and potential reversals. Analysing these gaps helps traders take benefit of the market without missing out on opportunities.
However, trading gaps are very risky, too. The gap may only be temporary and may fill in, within a couple of hours, which can lead to losses for traders. Hence, using risk-mitigating strategies is essential.
Gap fill is a phenomenon where the price of the stock gets back to its pre-gap level after a certain duration. So, when a gap-up is filled, the stock price falls back to its normal level. When a gap-down is filled, the stock price rises back to its regular level.
Such fills act as correctors when gaps get created due to quick actions by traders, without thorough judgement.