Gap Trading – What Is Gap Up And Gap Down Strategy?

If you invest and trade in the stock market, then you must have come across the gap up gap down strategy. It is a simple and effective way used by stock market traders to check on the differences in the price of a stock from one trading day to the next. This price difference is called a “gap”. It happens when a stock opens at a price which is higher or lower than what it was at closing on the previous day. When traders see these gaps, they can make profits by predicting how the stock will move next.

If you are looking forward to learning more about this gap-up strategy and gap-down strategy, here is the guide for you. Read on to understand how you can use the gap up gap down strategy to grow your wealth and make huge profits.

What is Gap Trading Strategy?

Before we delve deeper into the topic, let’s first understand the fundamentals of the gap trading strategy. In simple words, gap trading is all about making money from the difference between a stock’s closing price one day and its opening price the next day. “Gap Up” is when the opening price of a stock is higher than the closing price and “Gap Down” is when the opening price is lower. 

But the question is how traders make profits using these strategies.

Well, stock market traders study these price gaps to guess what the stock price will be the next day. More often than not, prices will move back toward the level they were at before the gap, and traders use this movement to make their trades. 

Let’s understand it using an example:

Suppose, there is a gap up. What happens next is that some traders might expect the price to fall back and decide to sell. If there is a gap down, traders may expect a price rise and choose to buy.

Why Do Prices Gap Up?

A "gap up" happens when the stock opens at a higher price than it closed the previous day. The major reasons for a gap up opening include:

• Good news about a company, like better-than-expected earnings or a new product, can make people want to buy its stock.
• It could be because of strong market sentiment as well. When investors are feeling optimistic about the stock market or a specific company, they may rush to buy stocks, and this causes a gap up.
• Global news or events could also be the reason for gaps ups as news or events from around the world that happen when the market is closed can affect stock prices.

Important Note:

Despite all this, there is no guarantee that the stock would continue rising after a gap up. So, if you are a trader, make sure to consider other factors too.

What is Gap Down and Why Does it Occur?

On a similar note, a "gap down" happens when a stock opens at a lower price than what it closed at on the previous day. It might happen because of the following reasons:

• Bad news like a company reporting lower profits or losing a big client, can make investors sell the stock.
• If investors are feeling negative about the market or a specific stock, they may sell their shares, thereby, lowering the price of the stock.
• There could also be unexpected global events like political issues or economic changes, which can affect stock prices.

Types of Gap Trading Strategies

Gap trading strategies depend on the type of gap and how traders expect the stock to move. Here are some of the most commonly used gap trading strategies you can consider:

Breakaway Gap:

It happens when the price of a stock breaks out of a pattern where it has been trading in a narrow range. It usually happens on account of major news or a big shift in the stock market.

Runaway Gap:

Also called measuring gap, it represents a sudden change in the perception of a stock among traders, followed by strong buying or selling in the market.

Exhaustion Gap:

This happens near the end of a strong price movement. It means that the trend is running out of energy, and the stock price may reverse direction. It happens when traders make emotional decisions and rush to buy or sell.

Professional Gap:

This type of gap occurs when institutional investors, such as hedge funds or large financial firms, enter or exit a stock.   

Differences Between Breakaway Gap and Runaway Gap

Here are the major differences between two of the most popular gap trading strategies:

How Does a Gap Act as Support and Resistance?

Gaps can act as support and resistance in the stock market in a number of ways, depending on the type of gap and the direction of the stock price: 

• Downward gaps: Act as resistance once formed 

• Upward gaps: Can act as future support levels 

• Gap up: Can act as support when the stock price starts correcting 

• Gap down: Can act as resistance when the stock price starts moving upwards 

• Breakaway gap: Can indicate the start of a new trend 

• Exhaustion gap: Can suggest an end to a trend 

Tips For Professional Gap Trading Strategies

Here are some strategies that professional traders use when trading gaps:

• Wait for the gap to fill
• If there’s a lot of trading (high volume) during a gap, it is more likely that the price would keep moving in the same direction.
• Follow the market trend as gaps that go against the trend may not last.
• Set stop-loss orders to reduce your risk.

Conclusion

If you are looking for a way to make money in the stock market, then gap trading is one of the ways you can consider. The more you know why gaps happen and how they act as support or resistance, the more aware you will be while placing trades. However, make sure to follow the right strategy so that you can take advantage of the price movements.

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