Every trader applying the gap strategy has to find gaps in the market. Gaps can occur in reaction to different events. Different gap types will behave differently and should therefore be traded differently.
Common gaps are a product of sheer coincidence. They mean nothing and should be ignored by any trader. Common gaps can neither stop nor create a trend.
Common gaps is a gap type that occur especially in times and different types of assets with low liquidity, when only a few traders are in the market. If there are very few total trades, a few outliers in either direction can manipulate the price significantly and create a gap.
To identify common gaps, pay attention to the volume in the period they were created. If a gap was created in a period with relatively low volume, there is a good chance the gap is a common gap, a result of coincidence. The more volume the gap period has, the more significance has the gap. For some rarely traded assets this rule means that you can rarely trust a gap, if at all.
If you find a common gap in the market, just ignore it and continue your technical analysis as if there would be no gap at all.
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Breakaway gaps usually occur in reaction to news about an asset. While the market was only in a slow trend or in a sideways movement, as big news hit the market they cause the breakaway gap, which changes the entire chart significantly and starts a new trend almost every time.
An upwards breakaway gap will likely create an uptrend; a downwards breakaway gap will likely create a downtrend.
To identify a breakaway gap, watch for these features:
1) Size: A breakaway is at least as big as an average trading range for the asset. If you want to automate your gap trading or if you are looking for a clearly defined rule, you can use momentum indicators such as the average true range.
If the gap is bigger than the average true range’s value, you can trade it as a breakaway gap. If it isn’t, you can ignore it. Of course, this rule is just a suggestion, and you might want to use a factor for the average true range’s value to adapt to your trading strategy. In any case, you have to make sure that the gap is significantly large enough to qualify it as a breakaway gap.
2. Market situation: Breakaway gaps usually ignite an up to that point slow market. Therefore, you should look for breakaway gaps only in times of slow trends or sideways movement.
A runaway gap looks very similar to a breakout gap. A runaway gap, however, occurs not during quieter market periods, but when the market is already in a trend. Big news hit the market and confirm the already existing trend. Runaway gaps can lead to a pullback similar to the pullback after a breakout.
Still, they confirm the existing trend. As a trend follower or a swing trader you can use this information to know that the current trend and the movement are still strong.
Exhaustion gaps are the opposite of runaway gaps. After the market has moved strongly for quite some time, what ignited that movement has lost its significance and the market starts to quiet down. Exhaustion gaps are characterized by a gap in the direction of the preceding movement while the trading volume is low.
Usually, these gaps occur when most traders stopped investing in the continuation of the movement, but a few traders are still buying / selling – either because they follow a different trading style or because they do not understand the movement is over.
The easiest way to tell a runaway gap, on which you should invest, from an exhaustion gap, on which you should not invest, is to look at the volume: In general, you should never trust any movement that is the result of low volume.