A Window of Opportunity
Definition: the difference in price between a security’s opening price and it’s prior day closing price. This difference shows up visually on a candlestick chart as a space between candles.
When we do Gap talk, it’s a special language, so we need to be clear on some of the words in that language, so we understand each other.
Myth – Gaps Must be Filled
Many traders have lost their shirt on the cliche that Gaps must be filled, in other words that price needs to retrace back over a recent gap. See the illustration above.
Don’t fall into this Gap, and don’t fall in love with a gap, as if it’s some future certainty, cuz it’s not. Many times gaps are not filled…at least not right away. It might eventually be filled, like next week, next year, or next century…but it has no statistical, and therefore no tradable significance.
Fade The Gap
This is kind of like Fill the Gap, but it’s a circumstance immediately following a gap, where you trade in the opposite direction of the gap. So, if price gaps up. we sell short, and if price gaps down, we go long. So, there are times when betting on a gap getting filled is a really good idea from a statistical point of view. But not always. So, pay attention.
Follow the Gap
The is the most like thing we will do, but only under certain circumstances, like the moon is full, or it’s pay day, or the third Monday of the 2nd month…just kidding. But there are citation conditions that priced a gap, that make a profitable trade in the direction of the gap, very likely.
It all comes down to size…well at least that’s what she said 😉 But really, the bigger the gap, the more likely it means there’s some significant opportunity ahead. In terms of definition, the size of a gap is measured like so…
Gap Up equals today’s open price, minus prior day close
Gap Down equals the prior day close, minus today’s open
So, that’s how to measure the gap, we say a gap is small when this size is less than 40% of the average range in price over the past 5 days. And a gap is big when the range is greater than 40%.
We have a way of measuring this range, it’s called the Average True Range (ATR). This is the distance between the extreme high and low in a particular day, including the prior day close if it extends beyond today’s range.
Generally big gaps are better to trade, but for the sake of referring to a potential trade, we will often say things like, its a large gap up, or a small gap down. So, when we say something like that, you know exactly what we mean.
We can further describe gaps in relation to the prior day’s price action. So for example, if yesterday was a down day, and we have a gap up, we might say it was a big gap up, following a down day, and that gap opened above the prior days high. We would call the a UH. Check out this gap zone chart.
If we were to step back and look at where gaps occurred in terms of market structure, meaning where the gap occurred in terms of it’s location in the current trend, we could further qualify the gap that way.
And there are three basic areas of the trend that are notable, and have statistical significance, they are at the beginning, middle and end of a trend, and they are called Breakaway, Runaway, and Exhaustion.
Well, that’s all for now. Next time we will discuss various strategies and the probabilities that they are worth trading. And from this, we will have developed a very effective trading methodology.