Gaps And Their Correlation To Price Action Trading

Unless you are brand new to trading, you are probably aware of “gaps” and why gaps occur in the price action. However, it’s very likely that you don’t understand how gaps actually work. As a day trader, it is very important that you have an understanding of gaps and their correlation to price action trading. This article is going to discuss these gaps and what the likely expectation is once you find one, because most people have a true misconception of how price action works in relation to these gaps.

Understand first and foremost that we are not suggesting that you look to specifically trade gaps. What we are trying to do with this article is educate day traders as to the bias that you can expect whenever you find a gap on any chart and how to use that bias in relation to price action trading entries. Rather than try and explain all of this in a new article, I found the following multi-part article that was written by Ken Cahoun and posted at www.editorial.equities.com. Ken’s article had the following to say about gaps:

Trading gaps for swing and intra-day trades is a favorite strategy used by active traders. Also known as “windows”, these powerful moves often occur following major news or earnings-related news, and can provide excellent trading opportunities. This is because the price action is often institutionally-driven, showing extraordinarily high volume and volatility.

A gap continuation occurs when a stock (or ETF) price continues in the direction of the gap.These gap continuations trades are a favorite trading strategy for active traders, because of the high volume and volatility, plus price action that takes them to new highs. It is often erroneously assumed, by book authors and novice traders alike, that gaps reverse more often than not. This however is usually not the case. Most gaps continue in-trend, and traders should be on the lookout for these pre-market and multi-day gap trading opportunities.

Tip: check a 15-day chart of the S&P, Dow Jones or NASDAQ and see how often days continue in-trend following gaps, versus “fade” or reverse back into prior trading ranges. You will often find that gaps continue, using the broad market indices as a good overall barometer of gap trading behavior. Note that during strong up or down-trends, this tendency for markets, sectors and equities to continue in-trend is even more pronounced.

As with most stock and ETF entries (futures as well), it is often to simply look for in-trend continuation entries by using a buy-stop limit order that’s .35 to .50 (thirty-five to fifty cents) above the opening price following a gap, to trade an in-trend directional gap move. Check for yourself the percentage of time that stocks and ETFs continue vs “fill” or pivot following gaps, to confirm that for the majority of gaps, for instruments priced $20-$70/share, gaps do in fact continue the majority of the time.

Many trading books and courses mistakenly cherry-pick “gap fill” examples and give bad advice like “buy gaps down” or “sell gaps up”, when in fact gaps continue in-trend more often than not. Looking at recent longer-term 90-day charts of stocks like Netflix (NFLX), Green Mountain Coffee (GMCR), and even recent IPO charts like Facebook (FB) and others, one can find many examples of gap continuations.

However, there will be a small percentage of times where gaps will reverse, or “fill”, and astute traders can also be on the lookout for these. Those who, like the author, are breakout traders, do not like to trade gap fills or pivots, since trying to “outguess the market’s directional moves” is usually a losing proposition. Gaps are there due to institutional pre-market trading orders on high volume, so it’s wise to follow institutional money flow, by trading in-trend for most gaps, once they take out continuation support/resistance levels.

We will remind you again that we are not suggesting that you use his strategies to trade. However, we think Ken is correct about the bias tendencies and how price action reacts around gaps. What we want you to do is learn these biases and use them along with price action strategies to get a better idea of what to expect from the price action when you encounter a gap on your trading chart.

We actually like the idea of using the bias of seeing most gaps quickly filled versus worrying about what prices are going to do after the gap is filled. If you are following and reading the price action properly, then it won’t really matter what happens, because you will be prepared. This is where becoming proficient in price action trading comes in very handy. If you know and understand how to read a chart properly, and it can be done by anyone willing to put in the time and effort, you won’t have to worry about what prices may do at any time.

If you are interested in learning more about price action and our price action trading system or strategies, you can find additional information at http://priceactiontradingsystem.com/pats-price-action-trading-manual/.  We hope you have enjoyed our article on gaps and their correlation to price action trading.

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