Gap Trades
To
trade gaps effectively we must be able to identify them and understand their
characteristics; all gaps are not equal.
Traditional gap
theory (see evidence) describes the 3 main gaps in a trend sequence. We can
clearly see these gaps in the Apple chart below.
· First there is a break-away gap, usually near
(but not right on) the lows. This usually comes halfway through wave 1 and
breaks downtrend resistance. The break-away gap usually gives several chances
to buy as it generally dips back down again in the next correction and the
later for wave 2.
· The continuation / midway gap comes next. This
should come in wave 3, ideally wave iii of 3 and it is usually the gap that
comes on earnings or an event and breaks strong resistance. The continuation
gap does not give many chances to buy but there is a very high probability
set-up with great risk v reward if we buy early enough: as we know this gap
should come around half-way through the trend, we therefore know there is
plenty potential reward. We also know the gap should not fail and drop back
down to fill the gap, so this defines our risk. In the AAPL example, we
saw a $21 rally into the mid-point of the gap, so we should see at least
another $21 rally before the next large dip. If we bought near the open, there
was around $5 risk into gap fill. This gives $5 risk for >$21 reward which
is better than a 4:1 RR trade.
· The exhaustion gap comes when the trend
sequence is mature. It very often reverses for gap fill, although not always
straight away. Be especially careful if it comes near strong resistance which
breaks and then fails. If we identify an exhaustion gap we can use reversal patterns
to look for shorts back to gap fill.
Not all gaps are as clear as the ones described. Gaps that do not break any support or resistance or stay inside the previous session's range are sometimes called common gaps. These often reverse and fill the gap to the prior close.
All gaps
provide support and resistance, both at the gap window, and at gap fill. We can
form a trade around these levels in confluence with other factors, but we also
need a valid trade type. Support/resistance on their own are not a good enough
reason to enter a trade.