A gap is a change in price levels between the close and open of two consecutive days. Because of overnight news and traders sentiment, the stock will have a huge demand or supply the next day morning when market opens.
So, we can say that Gaps are nothing but lack of trading during the market open caused either by a day trader or professional institutional investors. There is a old saying that ‘all the Gaps will fill’. It is often observed that wider the gap introduces more volatility in the markets.
Gap Theory is one of the most simple trading strategy used across world markets by day traders. A gap trading strategy can be implemented when there is a change in price levels between the previous day close and current day open price.
Extreme sentiments among investors or traders make them to bring flood of orders during the market open. There are two kinds of gaps that can be observed in the market.
- Gap Up
- Gap Down
Due to some overnight positive news, there will be huge interest created for a particular stock, due to which demand for the stock would increase exponentially when the market opens next day. Open price will be higher that previous day close price.
A gap-down opening is when the stock price opens at a substantially lower level than the previous day’s closing price.
Both gap-up and gap-down openings pose a risk for a trader who puts in orders before the start of the market. The gap-up opening poses risk for a trader who has gone short (placed a sell order) on a stock, while the gap-down opening poses risk for a trader who has gone long (placed a buy order) on a stock. In the case of a trader with a buy (long) order, if the order happens to be the best ‘buy’ order (that is, highest bid price) at the opening bell, it will be executed and, thereafter, the price may plunge well below the price level of this trader.
Similarly, in the case of a trader with a sell (short) order (lowest ask price), if the order happens to be best ‘sell’ order (lowest ask price), it will be executed and, thereafter, the price may shoot up well above the trader’s executed price. In both these scenarios, the traders face the prospect of incurring huge losses if the prices do not correct the levels of the respective traders’ executed trades.
In general, technical analysis manuals define the four types of gap patterns as Common, Breakaway, Continuation, and Exhaustion.
Here are four rules to keep in mind when you have a gap:
- A gap up in price, into supply, after a rally in price, and in the context of a downtrend, is a very high-probability shorting opportunity
- A gap up in price, and in the context of an uptrend, is a lower-probability shorting opportunity and can actually be a buying opportunity on a pullback to demand when there is a significant profit margin above
- A gap down in price, into demand, after a decline in price, and in the context of an uptrend, is a very high-probability buying opportunity
- A gap down in price, and in the context of a downtrend, is a lower-probability buying opportunity and may in some cases be a shorting opportunity after a rally into supply when there is a significant profit margin below
In order to safeguard the market, exchanges decided to have a pre-opening session in which they will check the view of the traders either bullish or bearish and arrive at a opening price based on the orders placed by traders between 9:00 to 9:07 am. When the traders are bullish, they quote for very high prices than the previous day’s closing price and most of the orders would lie on higher price side, and so the opening price will GAP UP and open at a higher price than previous day’s close. When the price opens GAP UP most orders will lie around that range and will get executed quickly without any big fluctuation in stock price when the market resumes normal trading at 9:15 am.Similar is the situation with bearish activity.
At present there are three main gaps remains open in both nifty futures and bank nifty futures. These gaps are created because of the global market sentiments like FED rate policy announcements, Chinese market crash, Yuan devaluations and extreme Global market sentiments.