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Gaps are shock events that
jolt price up or down and leave an "open
window" to the last bar. Market folklore
(such as the infamous "gaps get filled")
seems to offer guidance, but, in reality, it has
little value. After all, many gaps never get filled.
So, how can we use these one-bar wonders to make
good trades and increase profits?
The first thing to do is figure out what kind
of gap you're dealing with. It should fall into
one of these three categories:
- Breakaway gaps appear
as markets break out into new trends, up or
down.
- Continuation gaps (also known as runaway gaps) print
about halfway through trends, when enthusiasm
or fear overpowers reason.
- Exhaustion gaps burn
out trends with one last surge of emotion.
 Certain
trades work best with each gap type, so proper
identification is extremely important. Use relative
location and key characteristics to place them
into the right category. There is also a psychological
aspect to recognizing the correct gap. Breakaway
gaps "surprise" because they appear
suddenly on charts you've ignored. Continuation
gaps "frustrate" because they pop up
where you think price should reverse. Exhaustion
gaps "relieve" because they print after
you hold on for too long.
Trade the trend on the first pullback to a breakaway
or continuation gap. In other words, buy the decline
after a rally, or sell the rally after a decline.
The odds favor a reversal back in the primary
direction, even if these gaps fill. However, the
pullback trade often requires great patience.
Markets retest breakout gaps right after they
occur, but many bars can pass before price returns
to test a continuation gap.
 Use
the continuation gap to target major reversals.
The first test usually occurs after closure of
the exhaustion gap. But, you can't trade it if
you can't find it, so here's a trick: Wait until
you can count three price moves, up or down. Then,
place a Fibonacci grid across the entire trend
and look for a continuation gap at the 50% level.
If you find one, place a limit order within the
gap and wait for a test to occur. The retracement
should provide enough support or resistance to
force a reversal. Once the gap is filled, place
a trailing stop and keep it close behind current
price action.
Modern markets fill many
continuation gaps for a bar or two before they
reverse. If you're a defensive trader, place your
order within this extreme price level. Many times
you won't get filled, but you'll save yourself
whipsaws from entering too early. Keep in mind
the filled gap presents low risk only when volume
remains flat and price doesn't gap back through
the old gap to get there.
 Exhaustion
gaps print blowoffs that end a trend. This last
burst of energy can occur on high volume, but
the lack of it doesn't change the outcome. Exhaustion
gaps fill easily, with price often heading lower
in a hurry. After this reversal, use multiple
time frame analysis to plan your next move. For
example, an exhaustion gap may also print a continuation
gap in the next larger time frame. Be patient
if this sounds confusing. Seeing this three-dimensional
landscape requires a sharp eye and a lot of charting
experience.
Read more articles from
Alan Farley.
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