Gaps can be very good trading signals OR they can be very powerful in making you lose. When reading this post keep in mind that I still don’t trade for real money myself and all this information is theoretical, but I will at some put all these knowledge’s to test. I do hope however that this post will give you something to think about.
If there’s a gap then this means that there’s opening price higher (in a rising market) or lower (in a falling market) than the previous day’s trading range (candlestick body). The gap often means that something has happened during the night (in case of stocks for example), something that made investors/traders want this stock a lot more or less, something that increased or decreased the value of the stock. Some important information that might not be publicly known yet. As I have talked about candlestick formation a lot now then I don’t think I need to bring any graphical examples how the gap might look like but just in case…here’s one example –
Gaps are very useful in case if possible trend reversals. It might show that there’s a lot of willing buyers or sellers around (depending on the direction of the reversal). If there’s a gap and you can also see some sort of confirmation in candlestick patterns then it’s a good time to start considering the odds. For example of a bullish signal you might see Harami or Doji around.
When buying gaps in the bottom we want to see that the market is already oversold. For example if you see a gap in the bottom as well as big volume, opposite color candlestick following the gapped candlestick and a gap upwards it might be a good time go long. For example on the following image you can see Engulfing followed by a big gap. However, at this point you might want to see some additional confirmation during couple of days.
When buying gaps at the bottom it might be good idea to put your stop loss limits to the open area of the previous day. Often the gap in the top is also an Exhaustion Gap. Buying top gaps is of course bearish signal, thus you would now sell short.
Sometimes, when you can see sort of a curve on the candlestick chart (independent of whether the candlesticks are filled or empty) without any gaps and then all of a sudden there’s a gap then you should buy or sell short in the direction of the gap.
Previously, when talking about Sakata’s theory, I also mentioned Three Gaps Up and Three Gaps Down formations. Usually the third Gap Up is good time to sell or sell short accordingly. Note however that these gaps do no necessarily need to be one after another, there can be couple of non-gaps between them as well.
There are also other cases where just one gap might indicate a strong buying force. For example if there was a high couple of months ago, the price is now on the level on the previous high and now there’s a gap moving the price even higher – this is a good indication that the buyers are not afraid of the reached high and the price will keep moving upwards. The same might apply also to shorter time frames and high in the nearer past. If the volume levels also indicate great trading within those prices it again might be a good confirmation.
And of course, IF there is a major downtrend and you can see a number of filled candlesticks going lower and lower and then all of a sudden there’s a long empty body above 2-3 previous downtrend long bodies then it might also be a good indication to go long.
These are just some examples of when trading a gap might be benefitial. Once you understand these basics you will be able to look for gaps and theories behind them yourself as well and hopefully take a nice profit from them.
Note that I am not an investing/trading advisor and these are merely observations and suggestions that *might* work or *might* not work. I mainly try to give you new things to think about yourself to improve your trading, to get more knowledgeable in your trading decisions and such. I’m learning it all myself right now and can not be considered a professional.