A gap occurs when the market opens at a significantly different price to the prior day’s close. Many stocks each day gap up or down a small amount, but when a stock gaps up or down by a large amount, we can look at that as a potentially very strong sign of intent.
A stock can gap because of many reasons. Perhaps particularly good or bad news about that company was released overnight. This might be a quarterly earnings report or news about a new product or service. Alternatively, the stock may be gapping due to big news that effects that whole sector or market.
The size of the gap gives us a view on the impact of that news. It is always best to place your spread bets on the market’s reaction to news rather than on your opinion of how that news will move the market. Always waiting for the market to lead you will result in a higher win loss ratio.
Measure the size of the stock’s gap as a percentage of its price. This allows direct comparison of multiple gapping stocks. Stocks that have gapped outside of the prior day’s range are especially important. Gapping stocks in general tell us that something significant has moved this company’s price, so there will most likely be more traders than usual interested in this stock. Increased volatility can mean increased opportunity for profits.
If you are trading intraday, then you can see if that stock continues on in the direction of the gap or whether it moves to fill that gap. Look for breakouts to new highs and lows if the stock starts trending. If a stock gaps up and then continues that move, it tells you that buyers are in complete control and long positions have a good chance of success. Conversely if a stock gaps down and continues falling then it tells you that sellers are in complete control and short positions have a good chance of success.
For end of day traders, these same signals apply, but they must be put into context. A stock that gaps up does not necessarily mean that a profitable rally is about to start. But if that stock is approaching a level of resistance on increasing volume and then gaps up through that resistance level, the chances are that you have a good candidate for a long bet. On the other hand, if that stock has been rallying for some time and the final candle in that rally is a gap up to a long candle that has a short body and a long tail on volume that is three times the amount of prior bars, then the chances are that you have a volume blowout on that gapped up stock. A long position at this point would not be as good an idea.
Gaps on their own are good indicators that some significant activity has moved that stock. If the stock in question has gapped more than a couple of percent and the gap puts the open outside the prior day’s range, then that gap is indeed likely to be significant. However, you need to put that gap in the context of recent price action to understand and profit from it fully.