How To Trade Price Gaps Like a Pro
A common phrase exists among traders. "Price gaps get filled". But how often do they get filled? and what does a price gap mean? If you're a stock trader, crypto trader, or investor interested in learning about gaps, this post is for you.
What is a Price Gap?
A "price gap" occurs when a space appears between one candle close and the next candle open. Gaps happen during volatile markets, overnight, weekends, or illiquid markets. Here's an example of when the S&P500 was gapping down during the 2020 decline.
The prevailing theory is most gaps get filled, but what do we consider a gap-fill? How often are they filled? Are there any rules or guidelines to follow when trading gaps?
A price gap is filled when the asset's price comes back to that level later and closes the gap with a candle body. If it's just a wick or tail that covers the gap, it's not considered filled. The rate that gaps are filled depends on the market itself, the timeframe, and whether the gap is up or down.
Gaps get Filled 9/10 times
This theory of gaps is floating around the internet, so I tried finding the source to uncover the exact studies. On Bioequity.org there was a study done on 24 years of the NASDAQ. The study reviewed only on up-gaps. Down-gaps always get filled because of rising markets over the long term, whereas up gaps require a price retrace to fill. [Source]
The research followed index stocks with long-term uptrends and didn't account for down gaps since the assumption is that all down gaps get filled. Down-trending bankrupted or delisted stocks weren't considered in the study, as up gaps were all filled (unless a down-gap came after) since the stock was headed to zero.
By looking at all the up-gaps in the NASDAQ, the study found 91.4% of gaps get filled. The only time a down gap isn't filled only when the market gaps up after. Traders often call this an island bottom/top pattern since it looks like a floating island.
There is a worrying island bottom on the SPY at the very bottom of the March 2020 recession. 9/10 times the market will fill in these gaps, so maybe the S&P has to have a serious correction here, or this is the 1/10 gap that doesn't get filled. As Brian says, 'only time will tell'.
The Four Types of Gaps
Each type of gap has its unique traits and meanings. There's the common gap, the breakaway gap, the measuring gap, and the exhaustion gap.
- Common Gaps: A common gap is your regular everyday gap that isn't a part of any larger pattern. These often get filled the fastest and happen frequently.
- Breakaway Gaps: These happen at the end of a long price pattern and signify a start of a new trend.
- Measuring Gap: Otherwise known as a runaway gap or continuation gap, this gap shows in the middle of a trend, signifying a strong and ongoing trend.
- Exhaustion Gap: At the end of a long price pattern, the stock often gaps as a final push in the trend direction. This signifies the end of a trend and the beginning of a consolidation or reversal.
Where To Find Gaps
Gaps often occur when markets are closed for the night or weekend. Many traders close their positions before the week is over so they don't have their money at risk during the uncertain weekends. This is also why it's hard to find gaps in cryptocurrencies since they are 24/7 markets.
Pro tip: If you want to hunt for gaps in Bitcoin, use the Bitcoin CME market, which is closed on the weekend and therefore shows gaps that can be useful for trading.
Gap Finder Tools & TRI Resources
To find gaps on the chart, you can look through the charts, manually zooming in to find gaps, or you can use one of these handy tools.
On this online gap finder, you can put in the stock ticker and it tells you where gaps show up. This method isn't perfect, and I prefer using an indicator on the chart.
One of the programming wizards at TRI (you know who you are) created a gap-finding script called 'Simple Gaps,' which tells you where the gaps are on any chart. You can find the script here on TradingView.
In the TRI Library, you'll find this script and many others that members have added over the years. These scripts are a goldmine.
How To Use Gaps in your Trading
Gaps are an excellent trade location tool and an indicator of market sentiment. If it's a breakaway gap, you know the trend is changing, and if it's an exhaustion gap, you know a trend is ending. If it's a continuation gap, you know the trend will keep moving, and if it's a common gap, you know the market should fill it pretty fast.
There are many more nuances and details on how to use gaps in your trading, so if you want to learn how to use gaps within an all-encompassing trading strategy, we recommend you jump into the TRI education program. Gap theory won't come until week 4 of the level 2 program, so you'll spend lots of time first building your trading plan, learning all the basics, and then adding concepts like gaps later on.
To access all the other scripts in the library, get a free trial to TRI here. You'll get access to the close-knit community chat room where pro traders get together and discuss the market.
See you in the chat, gap hunters. #pma4tw