Trading the gap and go strategy
The Gap and Go strategy has a catchy name to it. Just as the name suggests, this is a fast paced, intraday trading strategy. The strategy can be applied to any markets as long as there are gaps in the price.
In a way, this limits the number of markets to which the strategy can be applied to. Still, many traders find the gap and go strategy to be one of the most easiest trading strategies available today.
There are no complex indicators use (unless of course, you choose to make it complicated) and the risks are quite tight, which makes this very appealing. However, in all fairness, there are no credible studies to back up the success of the gap and go strategy.
Thus, traders who use this method will need to trade at their own risk. The examples of the gap and go strategy outlined in this article (and in most articles) are done in hindsight. Traders should note that it is always easier to outline a trading strategy in hindsight rather than consistently make profits in real time.
Still, the gap and go intraday strategy is quite useful and the simplicity of this strategy makes it easy for you to adapt and build a customized trading system for yourself.
What is a gap and go strategy?
A gap and go trading strategy, as the name suggests is based on a market phenomenon that occurs on a daily basis. It depends on the type of market you are dealing with.
Gap and go is one of the most commonly traded strategies in the stock markets.
This is because gaps are regular occurrences in the markets. Gaps occur when price opens the next session above or below the close of the previous session. Gaps in the market occur due to large volume of orders that push prices. It also indicates a market imbalance.
Generally, traders are accustomed in seeing prices making a natural progression. For example, today's open would be more or less the same as yesterday's closing price. But in some cases, there can be gaps in the price. These gaps are a result of strong market orders placed in the pre-markets or in the after-markets.
Gaps can be a bit confusing to trade. For one, there is a saying that gaps are meant to be filled. This means that price tends to revert and fill the gap, either with a high or a low. But at the same time, gaps can prove to be powerful set ups.
In quite a few cases, gaps remain open for prolonged periods of time. This can depend on whether the security is able to maintain its momentum after creating the gap and continue in the direction of the gap.
With the gap and go strategy, you are basically riding the momentum in the price of the security. The strategy is very simple. Wait for the market to open and watch for the security to gap up or down. In many cases, you can find this information in the pre-market opening session, which will alert you to the big movers of the day ahead of the market open.
Once you identify the stocks that have gapped higher, you can go long. Similarly, if the stock has gapped lower, you can go short. Stops are placed a few ticks away from the opening price. For profits, you simply trail your stops until you are fully out of the market.
One of the benefits of the gap and go strategy is that if you are wrong, the markets will quickly show that. In many cases, the stops are relatively tight, but the profit potential can be immense.
The gap and go strategy is ideally suited for the day trader or the scalper.
Traders have taken this simple strategy to fine tune it with other filters. For example, small gaps are usually ignored depending on the volatility of the security that you are trading.
Some traders prefer to make use of moving averages and the overall trend before taking the trade. The general rule of thumb with such filters is that if the gap occurs in the direction of the trend, it is seen to be more reliable compared to a gap in the opposite direction of the trend.
There are two types of gaps which we will cover in the next section.
What does a gap up indicate?
When prices gap up, it means that the current open price is much higher than the previous day's closing price. This up gap is also known as a bullish gap. Conversely, when today's open price is lower than yesterday's closing price, it is a down gap.
As you can guess, a down gap is a bearish gap.
Gaps are interesting levels to watch in the markets as they can signify levels of support and resistance. Due to the different confusing aspects of gaps, traders can either get it right or wrong. A lot depends on the market context, which many traders tend to miss.
Within the bullish and the bearish gaps, there are also different names given to gaps based on where they occur.
- Breakaway gap
- Runway gap
- Exhaustion gap
As the name indicates, the breakaway gap typically occurs during the start of a trend. Here, price tends to break away and gaps from the previous closing price. There is more validity for the breakaway gap when you analyze it in the context of the previous trend.
Of course, a breakaway gap is validated only if price continues to move in the same direction of the breakaway gap and is able to maintain the trend.
The runway gap occurs during the middle of a trend. When this gap occurs, the markets are signalling that there is still more room to run. Identifying a runway gap can happen by analyzing the overall trend in the markets.
It is even better if the trend coincides with a breakaway gap and is validated by an existing trend. However, once the runway gap occurs, you should be careful because it can signal that there is only so much for price to move further.
The exhaustion gap is of course the final step. Here, price tends to gap after the trend has been well established. It is the last push in price before prices either begin to consolidate or signal a change in the trend.
Exhaustion gaps can be validated only in hindsight and there is no guarantee that the trend will reverse simply because of the appearance of the exhaustion gap. It is all about the market context that needs to be considered.
The chart below gives an example of the three types of gaps.
Chart 1: Types of gaps
If you look at the gaps in the above chart and the alignment of the moving averages, you can see that the trend changes after the final exhaustion gap is formed. Following this, price simply trades flat for a small period of time.
Later, after the resistance is formed at 158.39, price then breakout from this range. This marks the start of a new trend and thus, this can be categorized as a breakout gap. Following this, in the middle of the trend, you can see the runaway gap being formed.
After the runway gap is formed, price continues to move higher, suggesting that there is still more room for price to rally.
Gaps can look good in hindsight but trading them in real time can be quite a challenge. It takes quite a bit of practice when it comes to trading with gaps.
In the next section, we take a look at some examples of the gap and go trading strategies.
Gap and go trading strategy examples
The chart below shows an example of the gap and go strategy. Here, we use the one hour chart time frame. The horizontal lines that you see on the chart are basically the opening session of the trade.
Therefore, the first candle on this session indicates the gap, when you compare to the previous day’s close. The up arrows indicate places where price gapped higher. By simply eyeballing the chart, you can see that in most cases, the strategy is somewhat successful.
Chart 2: Simple gap and go strategy
But we also get to see some losing trades, or trades where price didn’t really make any major moves. As previously mentioned, some filters can be used to gauge the validity of the signals.
In the next chart, you can see the gap and go strategy being used with two moving averages. We make use of the one hour char time frame and the 5 period and the 10 period exponential moving averages.
The moving averages basically give an idea of the trend. They also serve as dynamic support and resistance levels. Here you can see an example of a trade which could have given strong profits over a short span of time.
Chart 3: Gap and go strategy with two EMA’s
By just adding the moving averages, we can see that the trade automatically filters out false signals. We only trade in the direction of the moving averages. In the above example, holding the trade for a period of 12 days gave a 4.96% return.
But of course, this is not always the case, as in some instances, you can expect price to also reverse or reach a profit level that is much lower. Still, the main idea of the above chart is to show how a simple strategy can use filters to gain strong profits.
Without adding any additional indicators, the gap and go can also be improved by taking into account key candlestick reversal patterns such as the island reversals which are common with gaps.
Pros and cons of trading the gap and go strategy
As with any trading strategy there are some pros and cons that come with it. No trading strategy is 100% fool proof and the gap and go strategy is no exception either.
For one, the gap and go strategy can be ideally used on the stocks or in index futures. Gaps are more common in these markets due to the fact that they operate during fixed hours only. It is the institutional traders who have access to the markets after closing or before opening.
You cannot apply this strategy to the forex markets for example. This is because the markets are open 24 hours a day. The only time a gap can occur is at the Monday’s opening session, or when the markets open after the weekend close.
Price openings after a holiday period can also result in gaps. Therefore, the frequency of such trades using the gap and go strategy is not that high in the forex markets.
The gap and go strategy can be a bit risky somewhat. Firstly, you need to have a good broker that can give you a good fill on your price. The spread definitely matters with the gap and go trading strategy.
Getting a bad fill on a trade can eat into your profits rather quickly.
It is best to stick to the main stocks such as the large caps or mid-caps. Stocks with good volume can, to a certain extent prove to be reliable with little chances of manipulation. This is not the case when you look at small cap stocks or even worse, penny stocks.
You can also trade futures or other markets where gaps are a common occurrence. One aspect is to use the futures markets to trade currencies. In this aspect, the trading strategy is ideally suited as gaps are often formed in these markets rather than trading the spot forex markets.
In conclusion, the gap and go strategy, as illustrated is a simple trading system that can be used in the appropriate markets. Due to the simplicity of the system, it also allows traders to build an automated trading solution based on the conditions.
The strategy can be used primarily for intraday scalpers but it can also be extended to short term swing trading as shown in few of the examples above.