Posted by forex at 2:54 AM
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1. Identify the type of gap. There are three main types of gaps. A breakaway gap occurs when a stock that has been trending sideways suddenly shoots higher or lower in price. A continuation gap occurs in a stock trending up or down, and moves in the direction of the trend. An exhaustion gap occurs at the end of the trend and though it moves in the same direction as the trend, signals a coming reversal.
2. Evaluate the gap when the market opens. Gaps in the direction of an existing trend tend to signal continuation of the trend. The trade then is to buy or sell so as to follow the move. The major exception is if the size of the gap is well beyond the typical range of the stock. If a stock that typically fluctuates by $.25 to $.50 during a single day opens up or down (in the direction of the trend) by several dollars, this could be a signal of an exhaustion gap and should not be chased.
3. Avoid trading common gaps. A common gap is one that occurs in a stock that is not strongly trending in any direction. These types of gaps can be caused by technical reasons such as payment of a dividend or expiry of options or futures. Because they don't act predictably, they should not be traded.
4. Follow the rules for other types of gaps. A breakaway gap that occurs on strong volume should be played in the direction of the new trend. A continuation gap can either be played in the same way as a breakaway, or you can wait for confirmation from new highs or lows (depending on the direction of the trend). An exhaustion gap should be faded (played in the opposite direction) by either buying a gap down or selling a gap up.
5. Watch for island gaps. An island gap pattern is formed when two gaps create a cluster on the chart that is unconnected from other price action. An island gap usually indicates a strong move in the opposite direction as the trend entering the island. For this reason, island gaps are sometimes called 'island reversals.'