A gap occurs when there is a significant and sudden rise or decline in the price of a security. Gaps can occur as measured by daily data or weekly data and can be found on charts frequently especially when the earnings of a company is announced. Gaps are essentially points of high or low demand. Gap ups are points where there is high demand while gap downs are points of low demand. The idea is that pent up demand will continue after a gap up which will cause prices to increase further while a gap down will cause a stock price to fall further due to low demand.
A breakaway gap is a gap that occurs at the end of a move after consolidation and moves in the reverse direction. For example, if there is a breakaway gap in a downtrend, the price of the security would most likely move upwards from then.
How option traders can make use of breakaway gaps?
Breakaway gaps are very significant to traders as it is very profitable to trade then. Breakaway gaps normally signal the commencement of a major move. Option traders can initiate bullish positions after a breakaway gap in the form of call options or spreads such as the bull call spread.
A measured gap is a gap that occurs in the middle of a trend. During a strong move that starts with a breakaway gap, a measured gap occurs thereafter. As the measured gap occurs, Traders should note that the trend is midway through.
How option traders can make use of measured gaps?
Since measured gaps represent the middle of a trend, option traders can use the measured gap to estimate when the trend will end. By doing so, a target price can be estimated. For example, if a breakaway gap occurs at around $10 and a measured gap occurs at around $20, the end of the trend will occur at a price of around $30.
An exhaustion gap occurs at the end of a move. An exhaustion gap can only be recognised after a price reversal. Hence, it is only on hindsight that one can identify an exhaustion gap.
How option traders can make use of the exhaustion gap?
When option traders know that an exhaustion gap has occurred, it is time to exit a position as a reversal is imminent.
Island reversal gap
An island reversal gap is a gap that moves in an opposing direction of the gaps that precedes it. If a breakaway gap, a measured gap and an exhaustion gap have all been gap ups, and island reversal gap will gap down.
How option traders can make use of the island reversal gap?
The island reversal gap is an indication that the trend has reversed. If the trend had been up previously, the trend will now move downwards.