Trading The Gaps Successfully

[torero]

Waking up with the market opening with a gap can be anxious and stressful for some and an opportunity for others. Gaps are a shock to the rhythm of the market due to recent news. The only way to adjust the imbalance is result of a gap.

There are many types of gaps and many ways to trade the gaps. Many books and courses discuss this phenomenon extensively, explaining the what, the why, and the how. Technical analytic approach to gap works best because it simplifies the phenomenon to make it easier to understand: identifying support and resistance in these gap structures. In short, simplicity trading is trading with success. Categorizing them can be beneficial if they can answer two logical questions: will the gap fill? And if yes, where is the threshold level to determining that the market is filling the gap?

Gaps happen when an imbalance of demand and supply, causing prices to spike one way or the other to meet the satisfaction of other side who are willing to come into the market and take the transaction. These spike areas are pockets of empty volume and this must be remembered because volume drives prices and without volume prices will not move. It’s common that the price areas where high volume are seen, the gap top and bottom areas become areas of support and resistance, meaning if these prices happen to show up again, expect same congestion due to same high volume (same market players entering or exiting the market) from the previous occasion.

One special characteristic about gaps is that the buildup was so tremendous force creating this gap, that it requires same or more force to keep it going in the same direction. If not, where no follow-through is in sight (i.e. no volume or no movement of prices away from the gap area), a gap fill may soon occur. This process will play itself out very quickly in a few hours within the open.



The above chart shows a gap that is quickly reinforced in the same direction. It quickly moves away from the gap area with good volume and pushed prices higher. It only pulled back to confirm the breakout using the top gap as support before continuing to move upward.

Whenever the prices break into the gap, very often it will fill it completely. Why? Because the gap has little or no volume so there is only a small number of buyers or sellers who have previous commitments in this area. This make the fill happen very quickly. Unless the market is very strong in the direction of the gap that it somehow goes midway into the gap and reverse or there is a resistance/support area created before the gap took place. In this case, many buyers or sellers have major commitments and it may cause an interruption to the gap fill as shown in the example below. The bar that pierces the gap now looks more likely the gap will be filled. Unfortunately, the resistance in the middle of the gap stood out and stopped the rally dead in its track. It later reversed back to the gap bottom.



One way to watch whether or not the gap will be filled is volume. Lack of commitment after the gap shows the direction might not hold up. Without new players coming to strengthen to push the trend further, the gap will most likely to be filled. The chart below immediately after the big fat red bar (high volume bar in Equivolume chart), volume immediately dried up (note small thin bars). One bar after another, the prices did not pierce the gap bar's low, making the bears nervous and bulls more confident that the gap may fill today.



Professionals love fading gaps against inexperienced excited traders who trade based on news. Staying calm and trying to understand price action in charts can help decipher what may happen next. Volume is crucial in determining the gap action: reverse and fill or continue the original direction. Gaps provide one of the most reliable setups with price stop and targets already determined immediately after they are formed, establishing normally a very favorable risk/reward ratio.

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This article was first submitted and posted at MrSwing.com.
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[Soultrader]

Great article Torero! I was quite interested in the way the candlesticks are plotted thick on high volume and narrow on small volume. Is there a tool available for Tradestation with the same function?

[torero]

Unfortunately not. Equivolume has been in the wishlist by many TS users for quite a while but as usual, TS shrugged it off. I ended up using SwingTracker just so I can use this for morning trade. I like it alot because it's very intuitive unlike the volume bars on the bottom of charts. Extremely useful if you ask me.