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PTMC team 30.11 2015

The effective trading strategy based on gaps

Hey there, Protraders!

Almost very trader, from beginner to professional, met such market phenomenon, as a gap in his practice. On the chart, it looks like empty space, i.e. the gap between the open and close prices of the neighboring bars. Such a gap indicates that on the market were not any purchases or sales at a certain price, and orders immediately began to execute at higher or lower prices.

The effective trading strategy based on gaps

Why the gaps occur? There are several reason for such price behavior. First of all, we should distinguish the real and imaginary gaps. The real gap occurs at a sharp imbalance between the volume of orders to buy or to sell. Such gaps often occur due to important news release. On the daily timeframe, this is derived from the fact that the news came out after closing the trades on the stock exchange. The imaginary gaps occur when one exchange is closed while trades by a certain asset are continued on the other exchanges. This can be clearly observed on the daily charts of different futures traded on the Chicago Mercantile Exchange (CME). While the CME does not work, the London and Tokyo stock exchanges are actively processing the orders to buy and sell futures contracts. As a result, trades in Chicago are opened on the next day considering past trades on other exchanges.

Features of gaps occurrence on the forex market

Trading on the Forex market is conducted 24 hours a day, 5 days a week, therefore gaps between daily bars can appear after the holidays or weekends. This may occur as a result of important political events or changes in demand on a certain currency, thuson Monday morning the market opens with a gap.

The reason for the sharp change in price serves, as a rule, the reaction of market participants on the important news, such as: the revision of forecasts in the important fundamental reports, the speech of the Fed's head, messages about strikes, wars, natural disasters, etc. The news, which strongly differ from analysts' expectations, have the strongest influence. As a result, the market has to take into account the new information quickly, that is accompanied by the influx of a large number of market orders.

When important news comes out during the trades, the gap can be formed on the charts of smaller timeframes, while on the higher timeframes it will not be visible.

Features of gaps occurrence on the stock market

On the stock market, the gaps usually occur when some important news on the company or on the industry in which the company is included, are published before the market opening. It can be surprisingly good data on income (Earnings per share), information on takeovers or mergers, decisions of regulating authorities and so forth.

Thus, opening with a gap up means that the broker has received large volume of orders to buy on the premarket, but could not find a sufficient quantity of orders to sell. Therefore, he was obliged to execute these orders at higher price, at which the traders were ready to sell the needed number of contracts.

The news about the accident on a major pipeline, naturally, will cause a reaction among the traders of oil futures. If such news comes after closing the exchange, then many speculators will want to liquidate their short positions. They will have to place their orders to buy with execution by market, i.e. immediately after opening of the exchange. This certainly will create the gap up, and opening of the trades will occur above the previous day close price.

Classification of the gaps

Gaps can be divided into four types: common, breakaway gaps, runaway and exhaustion gaps. The trader should learn how to distinguish them, since each type requires its own special tactics of decision-making.

Below are the examples of gaps on the daily chart of Alcoa (АА) company shares:

Classification of the gaps

Common Gaps

Often these gaps appear on the calm markets on which there are no clearly defined trends. Usually, they are overlapped relatively quickly, and the price returns to the previous parity. Such gaps are characteristic for the Futures markets with long-term delivery as well as for illiquid market with a small volume. Due to the low liquidity, the gap can be formed when executing a sufficiently large order to buy or sell.

In the case of common gaps, the prices do not tend to continue the trend, and update of the peak values (max or min) does not occur on the chart. The volume usually slightly increases, but soon returns to its average values. If there are no new extremums, and the volume is not changed, this suggests that traders remained indifferent to this market, and the significant movements are not expected.

The gap, that is formed after the payment of dividends, which sometimes can be found on the stock market on the day of accrual of dividends, also belongs to the common gaps. For example, if payment is half a dollar per share, then after this each share theoretically becomes cheaper at the size of payments. Such gap type, however, does not happen often, since in addition to the dividends, other fundamental and technical factors are also influenced on the price formation.

Breakaway Gaps

This gap is usually formed when the price “jumps” from its well-established corridor and starts a strong movement. A distinctive feature of the breakaway gap is a heightened trading volume several times more than usual. Such gap type can remain uncovered for a long time (sometimes for months). Herewith, the longer the price corridor was formed, the longer a new trend can last.

Runaway Gap

This gap type is very similar to the previous one except that it is formed in the middle of the trend movement. Similarly, it is observed a sharp increase in trading volume due to the addition of new market participants. After such a gap, the price usually forms new peak values, i.e. continues the trend for several more days. If this does not happen,then it is probably an exhaustion gap.

Exhaustion Gap

Such a gap occurs at the end of trend movement on the heightened volume, herewith the price does not form new peak values during the next days. Usually, the prices are stopped and then go in the counter trend direction. To understand that before you is an exhaustion gap is possible only after the price has moved against the trend and overlapped the gap. The formation logic of such a gap is based on the fact that larger quantity of small traders are willing to enter the market by trend, while the major market participants close their positions.

If the gaps are closed during one day, then they are called damped. In such cases, a temporary overpriced or underpriced cost of the asset tends to return to the previous levels. So, if company publishes the information about large dividends, then a share opens with a gap up. But, continuing the trading day, the traders can notice the low indicators of reporting, in such case they start to sell, and the price again returns to the value of the previous day's close, overlapping the gap. Many speculators, which trade shares intraday, use such a strategy during the release of the corporate reports.

The example of medium-term gap trading on daily timeframe of stock market

There are many strategies following which, the trades may benefit from a situation when the gap appeared. These strategies vary depending on many factors: trader’s working timeframe, features of the trading instrument, the nature of the information, that was the reason for the gap, and also the gap type. In each separate case, the trader should follow to the set of rules for creating and maintaining the position.

In case of common gaps, the trades are opened in the side of their closure. The profit potential in this case is limited by the gap range. For example, if gap was formed upward, then you can sell, if there are no signs of support for a new trend. Stop order should be placed above the previous high. The position is closed at the bottom point of the gap. When a gap down occurs, the trading is performed by the opposite rules.

If you have defined that the breakaway gap was formed, i.e. there is a large volume, an exit from the flat channel and new peak values, then you can open a trade in the direction of the new trend. Herewith, the stop order is placed at the lower edge of the gap in the game to increase, and vice versa, in the game for a fall. The real breakaway gaps are rarely overlapped. Therefore, waiting for the rollback, you can stay outside the game. The profit can be fixed, when appear the damping signs of the trend: reduction of the trading volumes, a lack of new highs or lows for several days.

If you have defined that runaway gap was formed, then you need to buy at once, herewith the rules of Stop order setting are the same as for breakaway gap. If the price does not form new peak values, then you should exit from the trade and re-assess the situation, since most likely you are faced with another type of gap.

Exhaustion gaps give very good possibilities for speculative trading, since after them a rapid counter trend movement is often formed. If you have defined that upward exhaustion gap was formed on the chart, start to sell, previously setting Stop over the last high. At the beginning of a significant fall in prices, the small speculators will be thrown out of the market which will serve as an additional catalyst to further reduce in prices. Exit from the position is best carried out when appear the signs of the trend weakness, such as reducing the volume and flat-type price movement.

Also, it makes sense to use the gaps on the correlated markets. For example, if a breakaway gap is formed on the gold market, but on the platinum and silver markets, prices have not changed much, the trader can make moveahead of the curve on the market, which has not reacted to the news yet. However, such tactics should be treated with caution, as news can only refer to one instrument and only indirectly affect the related instruments.

The example of intraday strategy for gaps trading

This strategy is quite simple to implement, therefore any trader can test it in the Protrader trading terminal.

The feature of this tactics is the entry into the market 1 hour after the beginning of trades. During this period, professional market participants form some starting range, on the exit from which the position will be opened. This is the time you can use in order to select the shares for trading. When choosing the shares you should give preference to those cases, where the size of the gap does not exceed 1-2 average daily trading ranges. The possibility of the strong factors’ presence on the market is increased for larger gap sizes, and the possibility that gap will be closed on the same day is greatly reduced.

If the market opened with a gap up, but there is no enough support from buyers for continuing the growth, the price can start to decline in the attempts to close the gap. An hour after the start of trading, look at the minute chart and set a Limit order to sell at 1-2 ticks lower than local minimum.

After opening the position, protective Stop is set immediately after the last price rollback. The level of profit fixation is set at the previous day’s close price. In the case, when the gap is not closed during the trading day, the position must be liquidated at market price at the end of the trades.

Let’s consider a few examples. The share price of the company “Intel (INTC)” was opened 14th October 2015 with a gap down. Following the rules of this system, we wait for the formation of the price range within 1 hour after the market opening. Set the Buy Stop order on the tick above the range of the first hour, i.e. at the level of $ 31.62. We set protective Stop order below the last rollback level at the price $31.22. As we can see, the position was closed with profit at the level of previous day’s close price $32.05.

The example of intraday strategy for gaps trading

The share price of the company “Jonson & Jonson (JNJ)” was opened 13th October with a gap down. We open a long position on the breakthrough of the first hour trading range at the level of $95.50, and then set Stop under the last rollback at the level of $95.10. Fixate the position at previous day’s close price $96.00

The example of intraday strategy for gaps trading

The share prices of the company “Disney (DIS)” were opened 21th October 2015 with a gap up and became a candidate for trade by this trading system. As we can see, the first hour trading range was broken shortly before the market closure. We open a short position by DIS at the level of $110.50. Then set protective Stop order above the last rollback at the level of $111.30. Since before the ending of the trades, the gap was not closed, and the target of the trade at the level of previous day’s close was not achieved, we exit from the position a few minutes before the market closure at the level of $110.10.

example of trading gap (chart of Disney company)

The share price of the company “Caterpillar (САТ)” was opened 27th October with a gap down. We open a long position on the breakthrough of the first hour range at the level of $ 70.85. Then we set immediately the protective Stop order under the last rollback of the price at the level of $ 30.35. We set the target of the profit fixation at the upper border of the gap$ 71.30. Not reaching the target, the price turns and reaches the protective Stop order. Thus, this trade is closed with a limited loss.

example of trading gap (Caterpillar chart)

Most of the gaps can be closed during the first hour of trading, so we just skip over those shares. Besides, the price can sometimes get out of the first hour range not in the direction of the gap closure, but continue to move on. We also ignore such cases and do not use them in the trading system.

Conclusion

Trading by this strategy can be a good start for the trader who wants to learn the working skills with gaps. Gradually, studying different types of gaps, the trader sees the market situation in which they arise, as well as meet with the different character of the price behavior in relation to the gap. With the growth of skill, you can start to use the Time & Sales and Market depth in the trading in order to determine the strongest levels of support and resistance, as well as calculate the intentions of the major players. All this will be an incentive for an in-depth study of the market mechanisms, the choice for trading other instruments and creation of the profitable trading system that meets the individual requirements of the trader.

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