STA Blog

Price gaps are an essential concept in trading, often signalling strong market movements or potential reversals. Whether you’re trading stocks, forex, or cryptocurrencies, understanding gaps can provide valuable insights into market psychology and future price action. In this blog, we’ll explore the different types of gaps and how traders can use them to their advantage.

What Are Price Gaps?

A price gap occurs when there is a significant difference between the closing price of one period and the opening price of the next, creating an empty space on the price chart. This typically happens due to sudden changes in market sentiment, news events, or after-hours trading.

DAX

Types of Gaps and Their Implications

Not all gaps are created equal. Recognising the type of gap can help traders anticipate the next market move.

1. Common Gaps

Common gaps, also known as trading gaps, are the most frequent and usually occur in relatively stable market conditions. They often appear in sideways or range-bound markets and do not typically indicate a strong price trend. Unlike other types of gaps, common gaps tend to be filled quickly as the price returns to its previous levels.

How to Trade: Since these gaps are usually temporary, traders often anticipate their closure and may use mean-reversion strategies to capitalise on them. Identifying support and resistance levels within the range can help in planning trades.

2. Breakaway Gaps

Breakaway gaps appear at the beginning of a new trend, often breaking out of a consolidation phase or major support/resistance level. They indicate strong momentum and are usually accompanied by high volume. Traders see breakaway gaps as confirmation of a new trend direction.

How to Trade: Look for confirmation through follow-up price action and volume increase. Avoid fading (trading against) these gaps unless there are clear reversal signals.

3. Measuring (Runaway) Gaps

Measuring gaps, also known as continuation gaps, occur within an existing trend and indicate that the trend is likely to continue. These gaps usually form in the middle of a price movement and act as a sign of strength.

How to Trade: Traders can use these gaps to measure the likely extension of the trend. Entering positions in the direction of the prevailing trend can be a profitable strategy.

4. Exhaustion Gaps

Exhaustion gaps form near the end of a strong trend and may signal that the trend is losing momentum. These gaps often appear after an extended price move and may be followed by a reversal or correction.

How to Trade: Look for signs of decreasing volume and bearish candlestick patterns. If the gap is filled quickly, it confirms that the trend may be reversing.

5. Island Reversal Gaps

An island reversal occurs when a gap forms in one direction, followed by a subsequent gap in the opposite direction, leaving an isolated cluster of price action. This pattern is a strong signal of a reversal.

How to Trade: These gaps indicate a shift in sentiment. Traders often wait for confirmation before taking positions in the new trend direction.

Final Thoughts

Gaps can offer powerful trading opportunities, but they also come with risks. Understanding the type of gap and its market context is key to making informed decisions. As a general theme cash equities are more prone to gaps, 24-hour FX markets are less likely.

Using volume analysis, trend identification, and technical indicators alongside gap trading can improve success rates.

Before trading gaps, ensure you have a solid risk management strategy in place. Stop-loss orders and proper position sizing can help mitigate potential losses when trading these volatile movements.

Have you traded gaps before? Share your experience in the comments below!