We are currently experiencing very volatile markets and it is not uncommon these days that prices of individual companies fluctuate by 10% within a week. This often leads to so-called gaps, to German course gaps. In this article, we want to show some examples and present the associated possibilities.
Formation of gaps
Gaps arise from a period of inaction. Shares usually have a fixed closing price and an opening price the next day. In the meantime, the stock is not actively traded. Of course, trading interests still arise during this period and market participants want to buy or sell this share. If you put all this new information together, you get a new price for the opening of the stock exchange. So a Tesla stock may close at $ 900 in the evening and open at $ 910 the next day. In this example, there is an up gap.
Gaps using the example of the Tesla share on the daily chart:
The areas highlighted in red are gaps. There are more gaps in this chart 😉
Taking advantage of gaps
There is a multitude of strategies that only deal with gaps and are profitable. It is important not to trade every gap found. It is also important here to define and follow a strategy with a fixed set of rules for entry and exit. A backtest is often worthwhile to find out whether the instrument to be traded is suitable at all. Of course, indices and commodities can also be traded with gap strategies, since these markets usually have a fixed close of trading. It is only relatively difficult with currencies, as these are tradable 24 hours a day. So you have to wait for the gaps in currencies, which definitely occur at the weekend.
What could a gap strategy look like?
As already mentioned, there are a variety of options. The basic requirement is the existence of a gap. Already when defining a gap there are different opinions, but all of them have their reason for being and offer opportunities. One side defines a gap as the gap between the closing price on one day and the opening price on the following day (marked 1 in the lower chart). Others define a gap as the gap between the extreme price on one day and the opening price on the following day (marked 2 in the lower chart).
If you look at the order book and focus only on the prices that were actually traded, then the second interpretation of applying a gap strategy is more interesting.
The motive for a gap strategy is primarily to use the closing of the gap as a trade. Now of course you cannot trade every gap that arises because you would make too many losing trades. For this reason, almost all gap strategies have a defined set of rules for entry. For example, you can specify that you only enter the trade if the lowest price (with an up-gap) from the first hour of trading is undercut. This increases the likelihood that the price could go down on that day, closing the gap. Furthermore, one could define that the break described must occur within the second trading hour.
The following chart shows a simple example of getting started:
Now the important questions about stop loss and take profit have to be clarified. There are many different approaches here too, so the stop loss could be at the high of the first hour of trading or at the high of the breakout candle. The take profit could be 75% of the gap or the entire distance. The world of gap strategies is very large and hardly any strategy is like the other.
Tradimo also offers a gap strategy and goes one step further by opening the next trade after reaching the take profit, which also takes up the gap as a trade idea.