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Price Gap OpportunitiesTHE CMC MARKETS TRADING SMART SERIES
CMC Markets | Price Gaps 2
A gap in the price is exactly what it sounds like – a gap in which there is no trade, leaving blank space between two adjacent candles or bars. This doesn’t occur on line charts because they simply link one closing price to the next. In the case of candles and bars, if the low of the first bar/candle is higher than the high of the next day’s range, or alternatively the high of the first day’s range is lower than the low of the next day’s range, then this creates an apparent gap in traded ranges. In this guide we explore different types of gapping and strategies for response.
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CMC Markets | Price Gaps 3
Chart 1 demonstrates examples of both types of gap described above.
The first thing to look at is coping with the negatives that can occur with
gaps. As you know, a price gap is an area where no trade has occurred.
The main aspect of concern for traders here is that if their stop order
is located within this area then they will suffer from slippage. Slippage
occurs when there is no trade or insufficient volume available at a
particular price level. If a gap occurs, then the best the trader can hope
for is to be able to exit the trade at the level at which trade reopens.
Interestingly, for traders who use a fixed percentage position-sizing
method, the price gap may be of greatest danger. The fixed percentage
model means that the trader risks a set percentage of their capital on
each trade that they make – commonly 2% or less. When the trader is
determining how many CFDs to purchase on a given trade, they look at
their entry point and their stop loss level and divide the difference between
the two into the capital they are willing to risk. Here is an example:
Available capital $10,000 Entry price $2.00 Stop loss $1.90 Risk per share $2.00 – $1.90 = $0.10 2% of available capital $200 Position size 200 / 0.10 = 2,000 CFDs
Using this method, if the trader enters the trade at $2.00 and is
stopped out at $1.90, they will lose $200, or 2% of their capital. The
trader will make this calculation before each trade they make, which
means that position size will be dependent on their available capital
and the distance between the entry point and their stop loss level. This
is all pretty simple stuff, but there are some potential complications
that lie just below the surface.
As you read this it may occur to you that the best way to increase your
upside on winning positions is to place your stop loss order very close
to your entry point. Using the previous example, if you placed your
stop only 5 cents away instead of 10 and did the calculation again,
then your position size would double while not increasing your risk if
you get stopped out. There are, however, some serious implications
of behaving like this. The first and more systematically crucial is that
the trader should be determining their stop loss level in such a way
as to consider optimum placement rather than just maximising your
position size. The fixed percentage model maximises your position size
based on the ‘best’ placement of stop loss for the trade in question.
If you simply place the stop loss very closely, then you will likely see
trades get stopped out unnecessarily due to uncontrollable issues like
intraday volatility.
When it comes to gaps in the market, there is always a danger
of getting stopped out of a trade at a worse price than you had
anticipated. Even though you have carefully calculated your position
size to keep your risk small, this will be problematic if you exit at a lower
price than you had planned. Now imagine the combination of a very
close stop loss, a very large position, and a huge gap in the market.
You can see that your original expectation of 2% at risk can become
significantly larger. From a psychological perspective as a trader, you
need to come to terms with the impact that gaps will inevitably (but,
hopefully, not too often) have on your trading and the risk that you take.
What do gaps look like?
Chart 1
CMC Markets | Price Gaps 4
This largely covers off the negative aspects of price gaps and the
impact that they can have on your trading. However, gaps can offer
trading opportunities on their own as well as providing you in some
cases with additional confirmation of the strength of other classic
signals such as technical breakouts. While there are several myths
as to the interpretation of price gaps, it must be made clear that the
oft-stated adage that ‘gaps are always filled’ does not always hold true,
and in certain trading situations, acting in accordance with it may in fact
spell financial disaster.
In a later section of this guide we will take a look at a regularly occurring
gap and address some ways in which it may be dealt with. Suffice it to
say that any idea that a market event is inevitable is something that may
prove extremely costly, underlining the need to manage risk at all times.
J.J. Murphy says that markets, when they do gap, produce price gaps
that fall into three general categories:
1. Breakaway gaps 2. Continuation gaps 3. Exhaustion gaps
Each gap, when seen, has different implications for forecasting the
immediate price trend risks in the context in which it occurs.
Breakaway gaps
A breakaway gap, for instance, points to the beginning of a new trend.
It is a gap that occurs in the absence of a trend and is one that tends to
accompany the breaking of ranges. Note: breakaway gaps are seldom
filled, as price ideally ‘shoots away’ as the new trend takes hold. The
breakaway gap requires a degree of psychological strength to be dealt
with effectively by the trader who has been waiting for a breakout to
occur. Essentially, if you are dealing with price patterns (for example,
triangles, rectangles, etc.) then a breakout that is accompanied by a
gap should be seen as a significant positive. Sometimes, however, this
sharp jump in price may make traders nervous that they have missed
the move and by buying now are acting too late to see any benefit.
Keep in mind that these patterns are areas where supply and demand
are largely balanced, only to see one side suddenly break out and push
price in a new direction. This being the case, the trader should really be
more excited about breakouts that occur sharply than ones which are
much more modest in their nature. When the breakout occurs,
if the gap is accompanied by a spike in volume, this will likely increase
the trader’s confidence in the validity of the move that they are
witnessing. Again, this means that the trader needs to overcome their
typical emotion associated with fear that they have missed the move,
and instead gain confidence from the aggression with which the wider
market is moving.
You can see in chart 2 that when the breakout of the symmetrical
triangle occurred there was a significant spike in volume at the same
time. Interestingly in this case, the trader may have been quite cautious
at the time of the breakout because price had started to drift so far
toward the apex of the triangle. Typically, a breakout no more than
three quarters of the way to the apex is ideal. In this case, however,
the confirmation given by the gap and the spike in volume would likely
inspire a greater degree of confidence in the setup. Author Alan Farley
suggests that a spike on volume above the 60-period moving average is
the preferable measure for any spike that may occur.
Continuation gaps
Continuation gaps are gaps that occur after a trend has begun and
suggest a market trend that is moving easily and on moderate volumes.
When the prior trend (whether up or down) is underway, a gap that
appears (whether partially or totally unfilled) technically affirms the
prior trend as intact, and is likely to continue.
Note that these continuation gaps, when they occur, tend to become
support if they occur in an uptrend; conversely, in a downtrend such
a gap becomes a resistance. As a consequence, if this type of gap is
filled there is the prospect it may be an exhaustion gap. Martin Pring,
in his book Technical Analysis Explained, suggests that continuation
gaps may mark the halfway point from the start of a sharp trend
to where it finds eventual exhaustion, and for this reason they are
sometimes referred to as measuring gaps.
Exhaustion gaps
Exhaustion gaps suggest an end to the prior trend. Because they occur
at the end of trends, their particular characteristic is that exhaustion
gaps are always filled. (Here, ‘filling the gap’ can be in the form of
another ‘gap’ in the opposite direction of the prior trend.) Martin Pring
suggests: ’One clue that an exhaustion gap may be forming is a level of
volume that is unusually heavy in relation to the price change of the day.’
What do the different gaps look like?
Chart 3 shows the theoretical distinctions between the examples of
gaps. It demonstrates that, going into the price peak, the gap created
was in fact an exhaustion gap. As the price ranges, this gap’s creation
was ‘filled’ and the gap in the opposite direction of the existing prior
trend classifies it as an exhaustion gap. This particular exhaustion gap is
interesting in that a few days after its creation a new gap is created, this
time following through lower in the opposite direction. This second gap is,
in fact, a breakaway gap, in that there was no downtrend in the opposite
direction and the gap itself has not been filled. This particular pattern,
where an exhaustion gap is combined by an almost immediately following
breakaway gap in the opposite direction, is called an island reversal.
Incidentally, Alexander Elder adds one more type of gap to the above
list: the common gap. A common gap almost always occurs in low
volume, ‘trendless’ markets. They have little value for analysts other
than to confirm the lack of market activity and, for that matter, the
absence of trading opportunity.
CMC Markets | Price Gaps 5
How to cope with price gaps
Depending on which gap you are exposed to, you will likely be
responding by shifting your stop loss orders quite quickly. For instance, if
you are already in a position and have a continuation gap in your favour
you would likely move your stop up to the point just below (assuming
you are long) where the gap began. If the gap turns out to be an
exhaustion point, then you will get out of the position as soon as that is
shown to be correct. This allows you to get the most out of the position
while at the same time letting it continue to run if indeed it does have
significant momentum still on its side. The other benefit is that it’s not
making you decide whether it’s a continuation gap or an exhaustion gap
– because it can be tough to tell. You are basing your trades on what the
market does and not just on what you think it should do.
In the case of a price gap that goes against you, you are left with a stark
choice of what to do. Gaps against you, whether big or small, imply a
sudden loss. The psychological shock of that aside, the technical theory
does provide some disciplines as to how to prevent or at least minimise
the worsening of the already losing position.
The general rules of behaviour when faced with a losing position
caused by a gap relate to the interplay of price and volume immediately
following the price gap’s creation. Specifically, if volume is high and price
continues to move away from the previous (pre-gap) levels straight
after the gap’s appearance, the technical response is to not wait, and to
immediately exit the trade. In reality, however, you should recognise that
if the gap has breached your stop level then you need to immediately
exit the trade. The primary rationale for this is that you are now outside
of your reasons for taking the trade in the first place, and so need to exit
as soon as possible. Just because the gap has shifted your exit strategy
makes it no more solid a strategy to hold onto the trade.
Chart 2
CMC Markets | Price Gaps 6
SummaryIn the case of a gap that moves against you followed by a lack
of volume or hesitant price action, then one could wait for price
to retrace back into the created price gap, giving you a chance to
exit with a smaller loss. Notice the emphasis on ‘could’.
The fundamental market fact remains: price which has been
‘shocked’ into a price-gapping move (in this case against you) is
a signal that the balance of price risks are against your position.
The lack of price action after the gap may offer some hope of
lessening the loss, but the reality is that the overall strategy
should be to exit the position.
Chart 4 - Types of price gaps
Chart 3
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