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CFD trading: Gaps - what they are and how to trade them

Gaps appear regularly in the stockmarket and can cause both pleasant surprises and unpleasant problems especially when using leverage in CFD or online trading. A gap occurs either when a share or market trades in a range that was not touched the previous session. Until the advent of 24 hour trading in some liquid markets and in forex trading, gaps were very common, but they do not now occur that often, so for the purpose of this article the focus is on shares, where they are very important.

The main cause of gaps are news events, such as company reports, which in the US are often announced after the close of normal trading, and in the UK, usually prior to the open of the session. If the profits announced are below estimates or the accompanying statement is worse than expected, the share price might open significantly below the lowest price seen the previous day. This is excellent news for CFD traders who are holding short positions, but the problem lies with long positions as the trader may have a stop order in place and the shares may not trade here because there is no trading in the gap. What then happens is that the broker will close out the position at the first available price dealt in the market for that number of shares, and this can result in high volatility early in the session as stops are unwound. This also applies to limit orders, which may be filled at a better price than originally set by the trader.

The other side of the coin is if a company pleases the market or there is an announcement of bid interest, in which case long positions benefit and those holding short suffer losses. There are times when shares or the market simply blow off on the upside as the market tries to liquidate short positions, and this is known as a short squeeze – gap openings are often seen in these conditions.

For charting purposes, gaps appear more frequently on daily charts, where every day there is news or an announcement that could give rise to an opening gap. Gaps on weekly or monthly charts do occur, but there is some argument as to whether on weekly charts a relevant gap would have to occur between Friday's close and Monday's open, or whether it could appear outside the range for any five previous days (21 or thereabouts for monthly charts). There are four types of gaps as follows:

Common Gaps

These are usually small gaps that occur within the normal course of trading. For instance, if Far Eastern markets are very strong overnight, several FTSE 100 stocks might trade slightly above the range seen the previous day. These are also called trading gaps or area gaps, and can be caused when a share goes ex-dividend and trades below the previous day’s range. Often these gaps are filled in due course, which means that the share eventually returns to trade inside the gap, and some traders may fade the move on the view that the price will settle back from where it came and close the gap. Common gaps occur more often in shares that trade a range, and they are of little use for most CFD traders.

Breakaway Gaps

Breakaway gaps are highly tradeable and very important. The key here is that the share price breaks out of a clear trading range or congestion area. Take a look at the chart of Taylor Woodrow here which shows a major gap in March of this year to break out of a three month trading range – this was very bullish.




The area near the top of the range prior to the gap would previously be viewed as resistance (and the area towards the bottom seen as support). The fact that the shares broke away so decisively suggested many more buyers than sellers, and subsequent action was highly positive for those going long. Another aspect that is important here is volume, and again it can be seen that trading was very high on the gap so this reinforces the bull argument.

In this case, the gap was not subsequently touched, but occasionally the price might return to fill the gap, and if this happens the point the breakout occurred now becomes support, if the gap is to the upside, and resistance if it is a break to the downside. It is very dangerous in breakaway gaps to look to fade the move as the signal given is often very powerful.

Continuation, Measuring or Runaway Gaps

Continuation gaps occur towards the middle of a major move and can signal renewed interest in a trending stock. After a strong up move many traders who were not involved in the rally might wish to enter on a retracement, but this never arrives and then there is another wave of buying interest causing a second big trend move. This type of action can occur in takeover situations, where the increased likelihood of higher bids is realised by the market, and shorts are forced to cover positions to prevent further losses.

The chart shown here is Corus Group, and the second gap in December 2007 is a continuation gap. The reason these are called measuring gaps is that very often the expected target for the new trend is a repeat of the amount by which the previous move achieved. This is very much a rule of thumb, but it is interesting that the first breakaway gap on Corus occurred around 400p, and the continuation gap was at 500p or thereabouts, which gave an extrapolated target of 600p, and that was achieved two months later.



On the downside, these types of gaps often occur on a second profit warning from a company. This is where there is increased selling of the stock and may appear in panic situations leading to another big measured move down. Once again, volume should be watched and the general key is to go with the trend after the gap.

Exhaustion Gaps

Exhaustion gaps, as they signify, occur either at or near the end of a major move, and can be a signal of an impending trend change. It is important not to confuse these with continuation gaps, and it pays to look at the big picture here. The key is often in the subsequent volume, and high levels of trading with big price moves between the previous day's close and the new opening price are very important, as is the action during the session, and during subsequent days.

The best opportunities occur after a major bear market, and here the chart of Reuters shows an exhaustion gap at the end of March 2003, which was after the shares had fallen 90%. At this stage sellers were liquidating all their positions in almost panic conditions as the shares retested a recent low. This exhaustion gap was soon filled and then a couple of weeks later there was huge upside volume signalling a new bull market for Reuters.




Although exhaustion gaps are often only identified after the event, they are very important for longer term players looking for an entry point.

It can be seen from the above that gaps are highly significant in CFD and online trading, but should always be used in conjunction with the overall technical picture using price action and volume together.

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