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Back to the basics. Trading the Gap

Jason BondJason Bond ·

If you’ve looked at a daily stock chart before, you might have noticed gaps in between some days. Gaps tend to occur due to some catalyst, whether it be news, or extremely bearish or bullish trading in the overall market. Moreover, gaps could occur during market hours, if the stock is halted due to pending news or volatility. That said, gaps could potentially offer trading opportunities.

What You Need to Know About Gaps

As stated earlier, gaps occur due to some catalyst. Now, this could be due to earnings or a significant change in company fundamentals. For example, if a company reports strong quarterly earnings results that tops the Street estimates and the company provides guidance above the consensus estimate, then the stock could open up higher, which would be considered a gap up. The opposite is true here.

In general, there are four types of gaps: breakaway, continuation, exhaustion and normal. Breakaway gaps tend to occur at the end of a price pattern, and could potentially indicate the start of a new trend. For example, if a stock formed a bearish pennant, and the stock gaps above the consolidation area due to some positive catalyst, it could be an indication that there might be a reversal of trend.

Continuation gaps are those that take place within a price pattern, and could be an indication that the stock will continue in that direction. For example, if the stock forms a bullish pennant, and the stock gaps above the consolidation area, it could be an indication that bullish trading could continue.

Exhaustion gaps are those that occur near the end of a pattern, and the stock is looking to make a final move to make new highs or lows. Now, normal, or common, gaps or simply those that do not fit within a price pattern and just represents a time when the stock has gapped. Let’s take a look at some potential setups and trades.

What To Do With Gaps

Now, there are two main schools of thoughts with gaps, either the stock builds momentum or it fills the gap.

Let’s take a look at an example of a Sangamo Therapeutics Inc (NASDAQ: SGMO).Source: TradingView

If you notice above, SGMO was trending higher up until it had a major catalyst. The company its quarterly financial results, but also announced a collaborative agreement with Pfizer Inc, which could potentially help the Sangamo Therapeutics grow its revenues and earnings. Consequently, this was an “extremely” positive catalyst in the eyes of market participants, sending the stock up significantly.

Take a look at Chromadex Corp (NASDAQ: CDXC).Source: TradingView

If you look at the area outlined by the rectangle, you’ll notice how the stock gapped down the day after its quarterly earnings report. However, the stock completely filled the gap, as some market participants may have saw the stock as undervalued, or believed the move was too extreme and thought it would mean revert.

Final Thoughts

Gaps could provide some trading opportunities, but they’re risky trades and only more experienced should use this strategy. Now, you’ll need to learn this type of pattern and how to look at catalysts. That said, you’ll need to look at a plethora of gap ups and gap downs to understand the pattern, before you start implementing these two basic strategies. Keep in mind, these are only two types of examples shown, and there are many other ways to play this gap.

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