Gaps and how to trade them
The two types of gap, the three things that can happen after an open out of range, a week of gaps marked on my chart, and the rules I use to trade them. Gaps announce that something has changed.
The idea
Two types of gap:
- IR, inside range: inside the prior range, but a gap to the prior settlement. These gaps tend to be filled more often than OR gaps.
- OR, out of range: these are more significant.
Gaps are important, and they announce that something has changed, or potential change. (Jim 'Legend' Dalton)
An open gap out of range (above or below the previous day's session high or low) signifies an important shift in market participants' thinking. The market is out of balance.
How to spot it
After an open out of range, one of three things can happen:
- Open continuation: the move away from prior value continues (discovery mode) until an opposing force slows the auction. Balance is eventually re-established in a new area. Do not fade the initial price discovery. Wait for clues that a bottom or high is forming or has formed.
- Open reversal: the auction rejects the gap and quickly reverses back to the prior area of balance.
- Open consolidation: gap acceptance, or at least the market takes time to think about it. Buyers and sellers both agree, and the consensus is to form a new balance zone. Value is re-established.
The time spent in acceptance is important. A balance that is established for only a relatively short period before returning to the prior balance area gives us essential information about the auction.
A week of gapsMonday opens with a large gap: a large OR gap. The opening 5 min range is established but fails to show a willingness to close the gap. Sellers drive the auction lower. Then a weak attempt to push through the open swing high: notice volume is weak. Opportunity to short.
Tuesday: a gap to the prior settlement, inside range (IR), quickly closed.
Wednesday opens with a smaller gap above the prior close, again a gap to the prior settlement, inside range. The smaller gap is eventually closed on a high-volume drive following a look above and fail. Notice the volume difference as trapped longs capitulate.
Thursday opens with a large gap below Tuesday's lows: a large OR gap. The opening 5 min range is established but fails to show a willingness to close the gap. Sellers drive the auction lower.
A look at some gaps, to be appended.
How to trade it
My gap trading rules:
- Trade in the direction of all gaps that don't fill quickly on the open. If I see initiation away from the gap open, it gives me a strong directional bias.
- The larger the gap, the smaller the odds it will fill that day. Most gaps will fill within the first hour of the session.
- 50% of a gap fill can often be a good target, especially on larger gaps.
- Identify local references and levels, and observe them for signs of gap rejection or gap consolidation.
- A gap is rejected if an opposing force responds to the higher or lower prices and the auction moves to close the gap.
- A gap move may consolidate. This is typical of larger gaps that find support or resistance at a prior reference. Balance rules.
- Observe volume. This is key.
- Low volume and a weak attempt to close the gap is a sign of weakness. Shorts taken.
- High-volume, impulsive PA is a sign that the gap may close, or that the move away from the prior range will continue.
Key takeaways
See it in the journal
Real sessions where this happened, written up on the day.
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