What is a Gap in Trading?
When the price of a stock or another asset opens above or below the previous day's close with no trading activity in between, this is known as gapping. A gap is a price chart area discontinuity in security. Gaps may appear when headlines cause market fundamentals to change rapidly during hours when markets are typically closed, such as after-hours earnings calls.
Economically speaking, a gap is a strong outnumbering of buyers over sellers, or vice versa, with no counter bids left to meet the bids, and the price suddenly "drops" to one side or the other. On 16 March 2020, for example, the price of oil had a real gap.
What is a gap in trading: the main reasons
Gaps often occur after the weekend, as many transactions do not occur on Saturdays and Sundays. However, it is important to remember that not all markets around the world are in sync: in the Middle East, Friday is a day off, while Sunday is a day of work.
Even when the brokers are off, there might be news that will push Friday's closing price up or down sharply when trading resumes on Monday morning. On the other hand, we only see quotes that will appear on the chart when the market opens. Although the Forex market does not work on Saturday and Sunday, it does not mean that nobody in the world is changing currencies on weekends.
It also happens on weekends, but less often, and usually only in response to exceptional events: a key rate increase or decrease, a terrorist act, or the outbreak of war. Then the supply and demand balance changes dramatically. Sometimes this phenomenon is not even called a gap, but a slippage - the price seems to slip sharply in some areas, where it can be difficult to open and close transactions. It is important to understand that brokers have nothing to do with the appearance of gaps on the chart, contrary to the opinion of some traders.
The main types of gaps
Now that we understand in general what a gap in trading is, let's talk about the classification of gaps. The best trading strategy for dealing with a gap depends on its type. Let's consider some classical types of gaps:
The simple gap - is called so by traders, as it does not imply any radical changes in the market. It appears on the weekend on the fact of important, but not long-term events, do not bring a change of trend or its strengthening, so it closes quickly enough.
A branch gap is a situation when currency pairs or shares have been in a sideways trend for a very long time and pending orders are piled up on the borders. When the price touches them, a so-called cascade triggering takes place - the next candle may open with a gap. This usually indicates that the trend will grow, and hence trades can be opened in its direction.
A gap of breakout - similar to the previous one, but with one exception: the trend may not continue, but the level, which was broken through, is no longer considered as strong support or resistance.
A gap of continuation of a trend. As the name implies, this gap occurs as an intensification of a movement already taking place. Bulls or bears accordingly see at the expense of this or that released news prospect in the further strengthening of a trend and also continue to buy actively.
A trend-ending gap is exactly opposite to the previous one, and it is formed on a particularly strong news trigger when it is clear that the current movement has nowhere else to go. The traders then quickly lock in their trades, which creates a corresponding gap in the backdrop.
How to Calculate a Gap
To protect your savings, you need to first avoid situations where the probability of gap formation is particularly high. An open position left open over the weekend, even with a Take Profit and Stop Loss set, can be extremely unfavourable to the trader, sending the market sharply in the opposite direction than expected.
However, if you anticipate a gap during an important economic news release and have an open trade at the same time, there is no need to close it, because every open close is charged against the spread. You can insure against unpredictable price jumps by leaving the Take Profit level at the current level or moving it as close to the current price level as possible. If the jump happens in the right direction, Take Profit will help you lock in a profit. Otherwise, a stop loss will minimize the loss.
How do I protect against a gap?
As experts in technical analysis say, any gap is bound to close, regardless of the type and reasons for its formation. This rule allows you to predict both the future prices' direction and the level that the quotes will reach in any particular movement. However, using this rule for trading is problematic. It is difficult to determine the moment of the beginning of the movement, at which the gap will be closed.
How long does the gap last in trading?
Practice shows that only 70% of the gaps are closed during the next trading periods, for the remaining 30% closure can wait very long, and the drawdown, in this case, can significantly exceed the allowable risk levels.