Gap Trading: Understanding Gap Up and Gap Down
Gap trading focuses on price gaps between trading sessions and how traders can profit from filling or extending them.
What Is Gap Trading?
Gap trading focuses on price gaps — areas on a chart where no trading occurred because price opened significantly higher or lower than the previous close. Gaps create imbalances that often attract price back to "fill" them, or they signal the start of a new directional move. Understanding gaps helps traders anticipate momentum and reversals.
Types of Gaps
There are four main types of gaps:
1. Breakaway Gap
- Occurs at the start of a new trend after a consolidation
- Often accompanied by high volume
- Usually not filled quickly — price moves away from the gap
2. Runaway (Measuring) Gap
- Occurs midway through an established trend
- Shows continued momentum
- Often used to measure the trend's remaining distance
3. Exhaustion Gap
- Occurs near the end of a trend
- Followed by a quick reversal
- Often filled quickly as price reverses
4. Common Gap
- Occurs in ranging markets
- Usually filled quickly
- Carries little predictive value
What Gaps Signal
| Gap Type | Signal |
|---|---|
| Breakaway | New trend beginning |
| Runaway | Trend continuing |
| Exhaustion | Trend ending |
| Common | No clear signal |
A gap up (opening higher than the prior close) suggests strong overnight demand, while a gap down (opening lower) suggests strong overnight supply.
How to Trade Gaps
- Identify the gap type using volume and chart context.
- For breakaway gaps: Trade in the direction of the gap with a stop just inside the gap.
- For exhaustion gaps: Look for reversal trades as price fills the gap.
- For runaway gaps: Add to existing positions in the trend direction.
Trading Example
A stock closes at $50. Overnight news causes it to open at $53 the next day, forming a gap up. If volume is high and the gap coincides with a breakout above resistance, traders may enter long with a stop near $52 (just inside the gap). If the gap is small and occurs after an extended rally with no clear catalyst, it may be an exhaustion gap best faded.
Common Mistakes
- Treating every gap as a trade signal
- Ignoring volume — high volume validates breakaway and runaway gaps
- Forgetting that many gaps fill over time
When to Be Cautious
Gaps in low-liquidity stocks or on holidays can produce misleading signals. Always confirm gaps with volume, news catalysts, and broader market context before trading.
Gap trading is popular among day traders and swing traders because gaps create clear reference points for entries, stops, and targets, often producing high-probability setups when properly classified.