THE CMC MARKETS TRADING SMART SERIES

Price Gap Opportunities

A gap in the price is exactly what it sounds like a gap in which there is no trade, leaving blank space between two adjacent candles or bars. This doesnt occur on line charts because they simply link one closing price to the next. In the case of candles and bars, if the low of the rst bar/candle is higher than the high of the next days range, or alternatively the high of the rst days range is lower than the low of the next days range, then this creates an apparent gap in traded ranges. In this guide we explore different types of gapping and strategies for response.

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CMC Markets | Price Gaps

What do gaps look like?

Chart 1

Chart 1 demonstrates examples of both types of gap described above. The rst thing to look at is coping with the negatives that can occur with gaps. As you know, a price gap is an area where no trade has occurred. The main aspect of concern for traders here is that if their stop order is located within this area then they will suffer from slippage. Slippage occurs when there is no trade or insufcient volume available at a particular price level. If a gap occurs, then the best the trader can hope for is to be able to exit the trade at the level at which trade reopens. Interestingly, for traders who use a xed percentage position-sizing method, the price gap may be of greatest danger. The xed percentage model means that the trader risks a set percentage of their capital on each trade that they make commonly 2% or less. When the trader is determining how many CFDs to purchase on a given trade, they look at their entry point and their stop loss level and divide the difference between the two into the capital they are willing to risk. Here is an example:

stopped out at $1.90, they will lose $200, or 2% of their capital. The trader will make this calculation before each trade they make, which means that position size will be dependent on their available capital and the distance between the entry point and their stop loss level. This is all pretty simple stuff, but there are some potential complications that lie just below the surface. As you read this it may occur to you that the best way to increase your upside on winning positions is to place your stop loss order very close to your entry point. Using the previous example, if you placed your stop only 5 cents away instead of 10 and did the calculation again, then your position size would double while not increasing your risk if you get stopped out. There are, however, some serious implications of behaving like this. The rst and more systematically crucial is that the trader should be determining their stop loss level in such a way as to consider optimum placement rather than just maximising your position size. The xed percentage model maximises your position size based on the best placement of stop loss for the trade in question. If you simply place the stop loss very closely, then you will likely see trades get stopped out unnecessarily due to uncontrollable issues like intraday volatility. When it comes to gaps in the market, there is always a danger of getting stopped out of a trade at a worse price than you had anticipated. Even though you have carefully calculated your position size to keep your risk small, this will be problematic if you exit at a lower price than you had planned. Now imagine the combination of a very close stop loss, a very large position, and a huge gap in the market. You can see that your original expectation of 2% at risk can become signicantly larger. From a psychological perspective as a trader, you need to come to terms with the impact that gaps will inevitably (but, hopefully, not too often) have on your trading and the risk that you take.

Available capital Entry price Stop loss Risk per share 2% of available capital Position size

$10,000 $2.00 $1.90 $2.00 $1.90 = $0.10 $200 200 / 0.10 = 2,000 CFDs

Using this method, if the trader enters the trade at $2.00 and is

CMC Markets | Price Gaps

This largely covers off the negative aspects of price gaps and the impact that they can have on your trading. However, gaps can offer trading opportunities on their own as well as providing you in some cases with additional conrmation of the strength of other classic signals such as technical breakouts. While there are several myths as to the interpretation of price gaps, it must be made clear that the oft-stated adage that gaps are always lled does not always hold true, and in certain trading situations, acting in accordance with it may in fact spell nancial disaster. In a later section of this guide we will take a look at a regularly occurring gap and address some ways in which it may be dealt with. Sufce it to say that any idea that a market event is inevitable is something that may prove extremely costly, underlining the need to manage risk at all times. J.J. Murphy says that markets, when they do gap, produce price gaps that fall into three general categories:

You can see in chart 2 that when the breakout of the symmetrical triangle occurred there was a signicant spike in volume at the same time. Interestingly in this case, the trader may have been quite cautious at the time of the breakout because price had started to drift so far toward the apex of the triangle. Typically, a breakout no more than three quarters of the way to the apex is ideal. In this case, however, the conrmation given by the gap and the spike in volume would likely inspire a greater degree of condence in the setup. Author Alan Farley suggests that a spike on volume above the 60-period moving average is the preferable measure for any spike that may occur.

Continuation gaps
Continuation gaps are gaps that occur after a trend has begun and suggest a market trend that is moving easily and on moderate volumes. When the prior trend (whether up or down) is underway, a gap that appears (whether partially or totally unlled) technically afrms the prior trend as intact, and is likely to continue. Note that these continuation gaps, when they occur, tend to become support if they occur in an uptrend; conversely, in a downtrend such a gap becomes a resistance. As a consequence, if this type of gap is lled there is the prospect it may be an exhaustion gap. Martin Pring, in his book Technical Analysis Explained, suggests that continuation gaps may mark the halfway point from the start of a sharp trend to where it nds eventual exhaustion, and for this reason they are sometimes referred to as measuring gaps.

1. Breakaway gaps 2. Continuation gaps 3. Exhaustion gaps

Each gap, when seen, has different implications for forecasting the immediate price trend risks in the context in which it occurs.

Breakaway gaps
A breakaway gap, for instance, points to the beginning of a new trend. It is a gap that occurs in the absence of a trend and is one that tends to accompany the breaking of ranges. Note: breakaway gaps are seldom lled, as price ideally shoots away as the new trend takes hold. The breakaway gap requires a degree of psychological strength to be dealt with effectively by the trader who has been waiting for a breakout to occur. Essentially, if you are dealing with price patterns (for example, triangles, rectangles, etc.) then a breakout that is accompanied by a gap should be seen as a signicant positive. Sometimes, however, this sharp jump in price may make traders nervous that they have missed the move and by buying now are acting too late to see any benet. Keep in mind that these patterns are areas where supply and demand are largely balanced, only to see one side suddenly break out and push price in a new direction. This being the case, the trader should really be more excited about breakouts that occur sharply than ones which are much more modest in their nature. When the breakout occurs, if the gap is accompanied by a spike in volume, this will likely increase the traders condence in the validity of the move that they are witnessing. Again, this means that the trader needs to overcome their typical emotion associated with fear that they have missed the move, and instead gain condence from the aggression with which the wider market is moving.

Exhaustion gaps
Exhaustion gaps suggest an end to the prior trend. Because they occur at the end of trends, their particular characteristic is that exhaustion gaps are always lled. (Here, lling the gap can be in the form of another gap in the opposite direction of the prior trend.) Martin Pring suggests: One clue that an exhaustion gap may be forming is a level of volume that is unusually heavy in relation to the price change of the day.

What do the different gaps look like?

Chart 3 shows the theoretical distinctions between the examples of gaps. It demonstrates that, going into the price peak, the gap created was in fact an exhaustion gap. As the price ranges, this gaps creation was lled and the gap in the opposite direction of the existing prior trend classies it as an exhaustion gap. This particular exhaustion gap is interesting in that a few days after its creation a new gap is created, this time following through lower in the opposite direction. This second gap is, in fact, a breakaway gap, in that there was no downtrend in the opposite direction and the gap itself has not been lled. This particular pattern, where an exhaustion gap is combined by an almost immediately following breakaway gap in the opposite direction, is called an island reversal. Incidentally, Alexander Elder adds one more type of gap to the above list: the common gap. A common gap almost always occurs in low volume, trendless markets. They have little value for analysts other than to conrm the lack of market activity and, for that matter, the absence of trading opportunity.

CMC Markets | Price Gaps

Chart 2

How to cope with price gaps

Depending on which gap you are exposed to, you will likely be responding by shifting your stop loss orders quite quickly. For instance, if you are already in a position and have a continuation gap in your favour you would likely move your stop up to the point just below (assuming you are long) where the gap began. If the gap turns out to be an exhaustion point, then you will get out of the position as soon as that is shown to be correct. This allows you to get the most out of the position while at the same time letting it continue to run if indeed it does have signicant momentum still on its side. The other benet is that its not making you decide whether its a continuation gap or an exhaustion gap because it can be tough to tell. You are basing your trades on what the market does and not just on what you think it should do. In the case of a price gap that goes against you, you are left with a stark choice of what to do. Gaps against you, whether big or small, imply a sudden loss. The psychological shock of that aside, the technical theory does provide some disciplines as to how to prevent or at least minimise the worsening of the already losing position.

The general rules of behaviour when faced with a losing position caused by a gap relate to the interplay of price and volume immediately following the price gaps creation. Specically, if volume is high and price continues to move away from the previous (pre-gap) levels straight after the gaps appearance, the technical response is to not wait, and to immediately exit the trade. In reality, however, you should recognise that if the gap has breached your stop level then you need to immediately exit the trade. The primary rationale for this is that you are now outside of your reasons for taking the trade in the rst place, and so need to exit as soon as possible. Just because the gap has shifted your exit strategy makes it no more solid a strategy to hold onto the trade.

CMC Markets | Price Gaps

Chart 3

Summary
In the case of a gap that moves against you followed by a lack of volume or hesitant price action, then one could wait for price to retrace back into the created price gap, giving you a chance to exit with a smaller loss. Notice the emphasis on could. The fundamental market fact remains: price which has been shocked into a price-gapping move (in this case against you) is a signal that the balance of price risks are against your position. The lack of price action after the gap may offer some hope of lessening the loss, but the reality is that the overall strategy should be to exit the position.

Chart 4 - Types of price gaps

CMC Markets | Price Gaps

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