6 Common Gap Trading FAQ’s

Although gap trading can be a little intimidating at first, with a bit of research you can learn how to take advantage of gaps. As you may already know gaps are created when the price of a stock on a chart moves quickly up or down. Keep in mind that gaps do not only exist on stock charts but on other financial instruments as well such as bonds, foreign exchanges and other derivatives. Once the price quickly moves, a “gap” is created in the price of the instrument. By learning how to identify gaps you can learn how to exploit them for profit. In this article you will find the 6 most commonly asked questions when it comes to gap trading.

1. What exactly is the difference between the dividend payout ratio and the dividend yield?

One of the most common questions amongst traders is the specifics of these two. Simply stated, the dividend yield (also known as the dividend price ratio) of a share is the dividend (payment made by a corporation to its shareholders as a distribution of profits) per share, divided by the price per share. By looking at it in a different way, we can also say that the total annual dividend payments made by a company during a year, divided by market capitalization equal the dividend yield.

Dividend Yield = Dividend per Share/Price per Share

In the world of stock trading, a dividend yield is usually a figure used to represent the earning on shares during one year. While this usually provides an accurate figure of how a company is doing, some investors prefer to analyze the dividend payout ratio since it is generally considered more useful when it comes to evaluating a company’s condition and financial standing. To calculate the dividend payout ratio, we use the following formula:

Dividend Payout Ratio = Dividends/Net Income for the Same Period

Let’s put this into perspective, by dividing the total dividends paid out over a period of time, we can estimate the fraction of net income that a company pays to its shareholders in total dividends. The part of the earnings not paid to shareholders as a dividend is left for investment in order to promote company growth.

2. “Gapping”. What does this term mean?

The financial markets close on Friday evening and open again on Monday. A trader can take advantage of this period of time by using a strategy known as “gapping”. (Tweet this) 

Gapping is a trading strategy where the participant will borrow short and lend long. The overall purpose of this strategy is to provide with the lender a better interest rate (since short rates will generally be lower than long rates).

3. What is the difference between all 4 gap groups?

Although a bit confusing a first, learning to identify all four gap groups can prove to be a valuable skill for any trader.

A breakaway gap occurs when the price of a stock breaks away from a congested area and starts to break away from an ascending or descending triangle. It is important that traders keep an eye on the volume as generally, the market will not return to fill the gap.
Breakaway gaps will generally mark the start of a new trend.
A common gap (which can also be known as an area gap, pattern gap or temporary gap) tends to occur when the market price is moving sideways. Usually, once a common gap occurs, the price will move back or go up to fill the gap in the coming days.
Common gaps are significant because they cannot normally be placed in a price pattern.
An exhaustion gap will generally take place once a price pattern is coming to its end and will signal a final attempt to reach a new high or low.

Finally, a continuation gap will take place during the middle of a price pattern and will indicate a sudden increase in the number of buyers or sellers.

4. What’s the importance of the PVI and how is it calculated?

The PVI (Positive Volume Index) is an important technical indicator that will give us a general measure of increases in trading volume from one trading day to another. The positive volume index can be used to get an accurate figure of how much trading volume has increased. As the PVI only takes into consideration days when trading increases from one period to another, if we notice a sudden increase in PVI we can then determine that price is appreciating on rising volume. On the contraire, if the PVI goes down, then we can safely assume that the price is declining on rising volumes. To calculate PVI we can use the following formula:

PVI=Previous Period’s PVI + {[(Today’s Closing Price-Yesterday’s Closing Price)/Yesterday’s Closing Price)] x Previous PVI}

5. What are the risks in Range-Bound strategies?

In a range-bound trading strategy, the trader will attempt to make trades based on price movements from the bottom to the top of the range and then down again. By using charts, we can easily identify the trading range and movement of a stock price in a specific period of time. While range-bound trading may seem like an easy trading strategy, the inherent risk of a breakout is a turn-off for many traders. Few markets will stay range-bound for extended periods of time and while swing trading the highs and lows of a channel can be a tempting strategy, a sudden breakout can spell disaster for even the more experienced traders.

6. What should you do after spotting an exhaustion gap?

While trading after spotting an exhaustion gap can be a very tempting strategy, the volatile nature of this strategy means that disaster could be right around the corner. A very important emotional component in the spotting of exhaustion gaps plays a vital role in whether a trader will make or lose money. Since exhaustion gap only remains open for a week or two (generally much less than that) prices will inevitably revert to their normal levels, so selling them to those who were late to the party in order to liquidate is generally a good idea.