Gaps occur when a stock price moves after the market closes. Learn what stock gapping is and the gap trading strategies used to maximise returns from an asset gapping up or down.
As you progress in your investment journey, you will continue to learn new and interesting things about the stock market and investing in shares. There is a cornucopia of knowledge out there, so acquiring as much relevant information as possible will help you to improve your strategy.
Have you ever noticed that one of your stocks ended the previous trading day at a certain price and then opened at a different price, seemingly after no activity at all?
This is called stock gapping, and it tends to happen when major news — such as earnings reports or external global factors — affects the price so significantly even with little to no trading occurring.
In this guide, we will explain all of the most important elements of gapping in the stock market, including how it can affect your trading, and share popular gap trading strategies to help you stay on top.
What is stock gapping?
Anyone who has been in the trading game for some time will have seen gaps from time to time. If you are not familiar with how they occur or why, it may leave you scratching your head, wondering how the price can change when no trading has happened.
If there is a “break” or a difference in the closing and opening price of a stock, that is called gapping Stocks can gap up and down depending on a variety of factors, and for unaware investors, they can be a frightening or exciting thing to happen — depending on whether the price rises or falls.
Gaps can occur in a variety of financial markets, but they frequently appear in the stock market — thus, stock gapping. They usually occur when liquidity in the market is low, so there are not enough buyers or sellers to reduce the chance of significant spikes or drops in the price.
However, even high-volume trading experiences gapping.
While there is no one specific reason for why a stock gap appears, it is often due to the release of important news, such as better- or worse-than-expected earnings reports , or company-related news (again, this could be positive or negative) that significantly impacts market sentiment after trading hours.
What does it mean to gap up and down?
Whether a stock’s price gaps up or down will depend on the news and market sentiment.
Gapping up means that the price is higher on opening than the previous day’s price. Gapping down means that the price is lower on opening than the previous day’s close.
Beyond gapping up and gapping down, there can also be partial gaps. A partial gap-up is when the price opens higher than close, but not above the previous day’s high price. In contrast, a partial gap-down is when the opening price is lower than the previous day’s close, but not below the day’s low.
Gapping up and gapping down, especially when it affects your portfolio, can be a positive or negative experience as an investor. It is important to know why the gaps appeared — doing your due diligence and reading the latest news and reports will help here — and then decide whether you need to rethink your strategy on that particular stock.
What does stock gapping mean for your trading?
Stock gapping may be hard to predict, but there are ways that you can use these events to your advantage. It will depend on your risk appetite and whether you have the right knowledge to use the gaps for your benefit.
Some traders, for example, will use the news of a positive earnings report to buy stock after trading has ended, in the hope that a positive gap-up will appear the next day. If it is gapping up on speculative news, others may see a sudden gap-up as an opportunity to short the stock.
Factoring gapping into your overall trading strategy is not for everyone. It is more complicated than standard research and buying/selling shares. However, it may be an opportunity for you to expand your portfolio by making quick decisions based on market volatility.
Tip: If you want to expand your knowledge of investing and trading, check out the eToro Academy.
What are the risks of gap trading?
Before you start gap trading, it is important to familiarise yourself with the potential risks associated with this strategy.
It is difficult to predict price movements
One of the main risks of gap trading is that it can be difficult to predict whether a gap will move in your favour. As gaps occur between the market closing and opening, there are no clear insights into how a stock will swing when the market reopens.
Monitoring company press releases and international news updates can provide some context, but will not give you a clear indication of how the stock will perform.
Gaps may not always be beneficial
While gap trading aims to take advantage of stock movements in your favour, gaps may only be beneficial sometimes. In some circumstances, you may find that a stock is worth more than it was at the close of trading, while at other times, your investment could be worth less.
It is important to take any potential losses into consideration before deciding whether to make use of gap trading strategies.
Gaps can impact stop-loss orders
Stop-loss orders are designed to help traders limit their losses. However, gapping can lead them to be filled differently than originally intended.
Ordinarily, if you were to place a stop-loss order of $35 on a stock trading at $40, the order would be entered if the stock was to fall below $35. If the price of the stock gaps, however, and opens at a price lower than the stop-loss value, such as $30, the stop-loss order becomes a market order, closing the position at the new, lower value.
Risk levels can vary depending on your investment strategy
Whether you intend to invest in, or trade stocks can impact the effect gap trading has on your portfolio.
If you are interested in short-term trading, the smaller movements of stocks caused by gapping can have a more dramatic effect, either positively or negatively. For long-term investors, changes in the day-to-day value of stocks may have less of an impact than their holistic performance over an extended period of time.
4 popular gap trading strategies
Just because a stock is gapping up or gapping down, it does not mean that it is the same type of gap. In fact, there are typically four different gap types, with investors using different gap trading strategies to leverage each occurrence.
Here is what you need to know about each of them:
Breakaway gaps
These gaps are a signal that a new trend is about to begin, since they appear at the end of a price pattern. You will see breakaway gaps at the top of uptrends and at the bottom of downtrends. Since they signal a potential trend reversal, breakaway gaps can become even more significant with high trading volumes.
Exhaustion gaps
As the name implies, exhaustion gaps are essentially a last-gasp attempt to reach either higher highs or lower lows. They appear near the end of a price pattern and signal that the current trend — whether up or down — is beginning to lose momentum. Traders often see exhaustion gaps as a sign that a reversal may be coming.
Common gaps
The most frequent of all stock gaps, common gaps happen regularly at the start of a new trading day, or even during trading hours if there is intense pressure one way or another to buy or sell. Unlike the other gap types, common gaps can’t be accurately placed into a price pattern.
Continuation gaps
Happening in the middle of a price pattern, continuation gaps are a clear signal that a surge of investors (whether buying or selling) have the same belief of where the stock is headed in the future. They appear during strong uptrends and downtrends, and follow the same direction as the underlying trend.
In addition to these four gap types, you should also be aware of the term “filled gap”. This happens when the market “fills in” the gap between the opening and closing prices, most often with common gaps.
Can stock gapping help your investment strategy?
Like every investment strategy, there truly is an art to stock gapping. Understanding a stock’s price patterns will help to reveal which type of gap has appeared, and then you can make your own decisions about whether making a play on the gap is a smart investment choice.
As an example, let’s take a look at breakaway gaps and how you might like to use them to buy the best growth stocks — or purge falling stocks — at the ideal time.
In most circumstances, breakout gaps appear after a significant event, whether that is a powerful earnings report or positive news about the stock’s potential for growth in the near future. Whatever the case, demand from buyers surges and a lack of supply causes the price to gap up.
Timing is critical here, and it is easy to miss a breakout gap opportunity if you are even just a few minutes too late. The main factor is that power often goes hand in hand with distance when it comes to breakout gaps. That means that if there is a huge rally for the stock at the start of the breakaway, the potentially higher and longer it can go.
How can you practise gap trading strategies on eToro?
If you are relatively new to investing, or if you have never really taken notice of stock gapping before, it may seem too complicated or risky to use your hard-earned money on gap trading strategies.
Yes, there is a pool of knowledge that you will need to acquire before you start making deliberate trades when gaps appear, but like most things, it all comes down to experience and time in the market.
So how can you practise some of the popular gap trading strategies discussed here without putting your own money at risk?
Tip: With an eToro Demo Account, you can try out all of these different strategies at your own pace — and with zero risk.
You can sign up for a $100K virtual eToro account where you can hone your financial skills, monitor the appearance of gaps, and deploy your own stock gapping strategies to see just how well you can do in the market with the real thing.
If you are ready to try gapping as you expand your investment portfolio, start trading with eToro today.
Join eToro today.
FAQs
- What does it mean to “short the stock”?
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To short the stock, also called shorting, refers to the practice of selling a security first and buying it back later. The investor acts — hoping the price will drop and that a profit can be made even though the price did not rise.
In this way, investors can make money when the market or stock falls as well as when it rises.
- How do you know if a stock has gapped?
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If a stock opens at a higher or lower price without any trading activity occurring between the time the market closes and opens, a stock will have gapped.
- How do you know if a stock will gap up?
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There is no real way of knowing if a stock will gap up, but positive business news, from strong earnings to product launches, may increase the chances of a gap-up occurring.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments.
This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Not all of the financial instruments and services referred to are offered by eToro and any references to past performance of a financial instrument, index, or a packaged investment product are not, and should not be taken as, a reliable indicator of future results.
eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.