How to trade Gaps like a pro?
and why, not all Gaps are equal?
In this article, I will explain:
What are GAPs and the psychology behind them?
Different types of GAPs.
What is a tradable gap according to Kacher and Morales?
How to trade a GAP?
Earnings linked Gaps.
Factors that increase the odds of a Gap trade.
What are GAPs?
Gaps are a price-action in which the price of a stock jumps up (or down) more than the minimum bid-ask spread. Hence, we can have a gap down or a gap up.
For a gap to be noticed by the naked eye on the chart, it has to gap considerably, generally 100s of multiples of the minimum bid-ask spread.
For a gap to be considered significant, the gap percentage has to be at least 1% of the close price.
Gaps, like every other aspect of price-action and charts, are also fractal and hence can be seen in all timeframes.
The higher the timeframe, the higher the significance a gap holds in the message it is trying to convey.
So, what is the message or psychology behind a GAP?
A gap up means that there is strong demand at the gap level (overnight on a daily level) and hence this can signal an increase in the momentum of the stock or the beginning of an uptrend. The higher the gap amount higher is the buying strength, and hence higher can be the ensuing momentum.
Similarly, a gap down signifies strong supply/selling at that level and may signal that the stock has more downside momentum to come.
The significance of these gaps is amplified depending on their timing and location on the chart.
A Gap at key support or resistance and/or on an earnings day (or a key announcement day eg. budget or federal reserve meeting day) would hold much more significance than a gap that occurs randomly inside the base.
Huge Gap ups or Gap downs around support & resistance would add more conviction to the change of trends.
What are the different types of GAPs?
There are 3 types of gaps classified according to where they occur with respect to a trend.
Breakaway Gap: These are gaps that occur at the beginning of a trend. Most of the time they occur while breaking out of a base, just inside of the base, or just after the breakout of the base. These are generally accompanied by monster volumes.
Runaway Gap: These are gaps that occur after a trend has been established and is underway in full force. Their occurrence further cements the fact that the trend is strong and would most likely carry on for some time in the near future.
Exhaustion Gap: These are gaps that occur at the late stages of a trend. They are often created by institutions only to distribute (or accumulate in case of a gap down) their holding to retail. This kind of gap generally means the peak of the distribution phase. Although the stock may trend up further post this gap, it does eventually face heavy distribution, and shortly after the trend reverses.
Gaps therefore can act as potent signals of a Stage 2 beginning or a Stage 3 topping (a topic for another article).
Image: Breakaway & Runaway gaps on Laurus Labs.
Image: Exhaustion Gap on IEX.
What's a tradable Gap according to Kacher & Morales?
Following are some characteristics of a tradable Gap according to Kacher and Morales, who discuss it in their book, “Trade like an O Neil disciple” ( i recommend the book to anyone who wants to learn how to buy a stock at a non-obvious buy point, called pocket pivots).
A buyable Gap (on quality leading stocks with strong fundamentals).
Gaps up >= 0.75 times its daily 40-day period ATR (average true range).
The volume of the gap-up day should be >= 1.5 times the 50-day SMA of daily volume.
Apart from these, I use an additional filter that the gap up opens at least 1% or more than the previous day’s close price.
How to trade a Gap?
There are more than one ways to trade a gap. For simplicity purposes, I will only talk about trading a gap up.
A tradable gap is buyable as soon as it occurs. An ideal stoploss would be below the lower boundary of the gap or the previous swing low.
Alternatively, as soon as the gap day high is broken to the upside, an entry can be taken. Stoploss would be below the day's candle or below the lower boundary of the gap (or the swing low below).
A more conservative entry would be to wait for the price to retest the gap upper boundary. This retest can sometimes go deep and undercut the lower boundary as well. A reversal from this retest/pullback provides a ripe entry with a much tighter stoploss just below this swing low.
It is imperative to assess the market conditions and one’s risk appetite while choosing the entry type. While type 1 entry may be forgiving during a bull market, type 3 would be suited more for a sideways market.
Image: 3 different types of entries are shown on Ingerrand along with 3 stoploss points.
Earnings Gap pivots:
These are special gaps (gap ups or gap downs) that occur on and around the earnings release of a company.
The earnings release is a pivotal point and any direction taken by the stock during/after this earnings release is likely to continue for a considerable period in the near future.
Hence these gaps are high probability set-ups.
Image: Earnings Gap up on Ingerrand.
Image: Earnings gap down on Kanchi karpooram:
Factors that increase the odds of a gap trade:
Gaps occurring above key moving averages of 200 & 50 DMA.
Breakaway gaps: those that break out of a long-term base and begin a fresh uptrend. Multiple green (accumulation) volumes inside the base are also constructive signs.
Breakaway gaps that gap up above a key moving average like the 200 or 50 DMA are powerful too.
Gaps that are accompanied by extremely high volumes.
Gaps that gap up >5%.
A gap that breaks out of a tight consolidation area.
That's all for this weekend folks.
Can't tell you how psyched I am to discuss this with my TA masterclass group today.
I have been busy curating a list of peak gap examples.
I will also provide them with my sakatasTGP scanner (tradable gap pivot) which is based on the work of Kacher & Morales (discussed above) so that they won't miss a single tradable gap in the NSE universe.
If you are interested in attending the live session (or accessing the recorded session) tonight at 8.30 pm please register below asap.
Thank you.
Until next week.
~ Prakash
Last week’s article on the High Tight Flag:
