Understanding Gaps in Trading: Types, Causes, and Strategies for Traders

Gaps play a significant role in trading, and create opportunities for traders to capitalize on sudden price movements early in the day. Whether you’re a beginner or an experienced trader, knowing how to react when a gap presents itself is key to staying on the right side of the market.

What is a Gap in Trading?

A gap refers to a price difference between the closing price of an asset on one trading day and the opening price on the following trading day. It occurs when there is no trading activity or very little trading activity during the post and pre market period between two days. Gaps are classified into two main types: true gaps and non-true gaps.

True Gaps vs. Non-True Gaps

A true gap occurs when the current day’s open is completely outside of the previous day’s range. In the case of a true gap up, the market would be opening above the prior day’s high. The reverse is true for a true gap down, opening under the prior day’s low. These gaps often result from significant news events, earnings releases, economic reports, or other market-moving catalysts that occur after the market’s close or before the markets open.

Non-true gaps are where the current day’s opening price is still contained inside of the previous day’s range, but not near the prior day’s close. Another term for prior day’s close, is settlement. If you ever hear someone refer to the settlement, it’s the same as the close. These non-true gaps are relatively smaller price differences that occur due to after-hours trading or pre-market activity without a catalyst..

Causes of Gaps

Gaps can be triggered by various factors, including unexpected news, earnings surprises, economic data releases, or geopolitical events. Positive news can lead to a gap-up, and negative news can cause a gap-down. It is important to know that sometimes seemingly “positive news” can produce a gap down if the market’s interpretation of the news is negative. An example that comes to mind is when we get “positive” jobs data during a Fed hiking cycle. It sounds good that jobs are getting added to the economy, however it implies that the labor market is strong, and thus the Fed can continue to hike rates, putting downward pressure on markets. The main takeaway is that the market’s interpretation of the data is what matters, not your traditional understanding of good vs bad.

Strategies for Trading True Gaps

Gap Fading: This strategy involves betting against the direction of the gap and assuming that prices will eventually “fill” the gap by retracing to the prior day’s high or low. Traders using this approach sell short during a gap-up or buy during a gap-down, expecting a reversal in price. The framework we use to fade gaps requires that prices are below the overnight extreme, and also have crossed through the opening print on the day in the direction of the fade, not the gap. The idea is that the overnight inventory is weak handed and will close their position if the direction of the gap does not continue immediately.
Gap and Go: This strategy focuses on trading gaps on high-volume momentum stocks, targeting quick profits by joining the “party” and hoping for a trend to be established at the market open. Traders using this strategy need to be aware that they are getting involved at bad trade location and should only enter with defined risk. Be it position size or stop under low of day, something must be implemented to avoid buying the top of a move, or selling the bottom of a move.
Gap Fill Reversal: This strategy involves identifying gaps that are likely to fade, and then looking to trade back in the direction of the gap once the gap has been filled and the structure has been repaired. The premise behind this trade is that the market is not finding acceptance inside of the prior day’s range, and we should start to continue in the direction of the gap once the “weak handed” participants have been shaken out. You have defined risk with a stop loss usually being placed just on the other side of the gap fill level.

Conclusion

Gaps offer potential opportunities for profit sooner in the trading day than later in the trading day. Whether it’s a true gap caused by significant news or a non-true gap due to after-hours trading, understanding the types and causes of gaps can help you make a better decision on the open. Embracing gaps as part of your trading strategy can improve your ability to generate profits when others may be too intimidated to get involved.