Understand gap trading (gap up - down - fill) — Stock-Market notes

WHAT is a gap?

WHY does a gap even exist? Because a stock chart is a record of executed trades. Between 3:30 PM close and 9:15 AM open, no trades execute — but buy/sell pressure accumulates (earnings, global markets, policy). At the opening auction, all that pressure resolves into ONE new price. If that price is far from yesterday's close, you see a visible empty band = the gap.

HOW big is the gap? (Derive the measure from scratch)

We want ONE number that says "how surprising is this open?"

Step 1 — Raw gap size. The simplest measure is just the distance jumped: $G = O_t - C_{t-1}$ where $O_t$ = today's open, $C_{t-1}$ = yesterday's close. Why this step? Price literally moved from $C_{t-1}$ to $O_t$ with nothing in between, so the difference is the size of the hole.

Step 2 — Make it comparable across stocks. A ₹5 gap means nothing on a ₹5000 stock but everything on a ₹50 stock. So we normalize by the previous close: $G\% = \frac{O_t - C_{t-1}}{C_{t-1}} \times 100$ Why this step? Dividing by price converts rupees into a percentage, so a gap on Reliance and on a penny stock speak the same language.

Step 3 — Judge if it's "real." Compare the gap to the stock's normal daily wiggle (Average True Range, ATR). Define a significance ratio: $R = \frac{|O_t - C_{t-1}|}{\text{ATR}_{14}}$ Why this step? If the gap is smaller than a typical day's range, it's just noise. If $R > 1$ , price jumped more than it usually moves in a whole day — that's a meaningful gap worth trading.

Figure — Understand gap trading (gap up - down - fill)

The four gap "personalities" (WHY they behave differently)

Type	Setup	Typical behavior
Common gap	inside recent range, low volume	fills quickly — fade it
Breakaway gap	opens beyond prior range, out of consolidation, HIGH volume	rarely fills — trend starts
Runaway (continuation) gap	mid-trend, in trend direction	continuation, partial fill
Exhaustion gap	after a long move, huge volume	trend ends, reverses & fills

Two core strategies

A. Gap-and-Go (momentum): enter in the direction of a strong, high-volume gap once price breaks the first 5-min candle high (gap up) / low (gap down). Bet: the jump was justified, trend continues.

B. Gap-Fill (fade / mean-reversion): enter against a weak, low-volume gap, targeting yesterday's close. Bet: over-reaction snaps back.

Worked Examples

Common Mistakes (Steel-man → Fix)

Recall Feynman: explain to a 12-year-old

Imagine a video game paused overnight. While paused, everyone shouts good or bad news. When you press play in the morning, your character teleports to a new spot instead of walking there — that empty jumped-over space is the gap. We measure it from where the character stood at bedtime (yesterday's close), not from the farthest step it took. If lots of people really meant it (loud = high volume), the character stays there. If it was just one kid overreacting, the character usually walks back to bedtime spot — that walk-back is the gap fill.

Flashcards

What is a gap in a price chart?

A price region where no trades occurred, created when today's open differs from yesterday's close.

What is the reference level for defining a gap?

Yesterday's close (not yesterday's high/low).

Define a gap up.

Today's open is above yesterday's close (

O_t > C_{t-1}

Define a gap down.

Today's open is below yesterday's close (

O_t < C_{t-1}

What is a gap fill?

Price trades back to yesterday's close, closing the empty gap region.

What kind of gap opens beyond the entire prior day's range?

A breakaway (full) gap — the stronger, out-of-range case, not the general definition.

Formula for percent gap size?

G\% = \frac{O_t - C_{t-1}}{C_{t-1}}\times 100

What is the significance ratio and when is a gap tradable?

R = |O_t-C_{t-1}|/\text{ATR}_{14}

; tradable when

R\gtrsim 1

Which gap type usually holds and doesn't fill?

Breakaway gap (high volume, opens beyond prior range).

Which gap type reliably fills same day?

Common gap (low volume, inside range).

Volume rule of thumb for gaps?

High volume → gap holds (ride/gap-and-go); low volume → gap fills (fade).

Reward/Risk for fading a gap up?

(O_t - C_{t-1})/(H_t - O_t)

; take only if

\ge 2

What signals an exhaustion gap?

A gap after a long trend on huge volume that then reverses and fills.

Connections

Support and Resistance — yesterday's close acts as the fill target/magnet.
Average True Range (ATR) — used to judge gap significance.
Volume Analysis — the lie-detector for hold vs fill.
Breakout Trading — breakaway gaps are gap-based breakouts.
Risk-Reward and Position Sizing — sets stop and R:R for fades.
Opening Range Breakout — first 5-min candle used in gap-and-go.

Concept Map

Hinglish (regional understanding)

Intuition Hinglish mein samjho

Dekho, gap ka matlab hai chart me ek "khali jagah". Raat ko market band rehta hai lekin news aur emotions chalte rehte hain. Subah jab market khulta hai to price seedha jump kar jaata hai — kal ke close se aaj ke open tak beech me koi trade hi nahi hota. Yaad rakho: gap ka reference hamesha kal ka close hota hai. Agar aaj ka open kal ke close se upar hai to gap up, neeche hai to gap down. Aur jab price wapas kal ke close pe aa jaata hai, us khali jagah ko bhar deta hai — usko gap fill bolte hain.

Ek important baat: gap up ka matlab yeh NAHI ki open kal ke high se upar ho. Sirf kal ke close se upar hona kaafi hai. Jab open poore pichhle din ki range ke bahar chala jaata hai (high ke upar ya low ke neeche), tab woh ek zyada strong special case hota hai — usko breakaway (full) gap bolte hain. General definition aur is strong case ko mat mila do.

Sabse important cheez: volume. Volume batata hai ki jump genuine hai ya sirf overnight over-reaction. High volume pe gap hold karega — isko gap-and-go se ride karo. Low volume pe gap wapas fill hoga — isko fade karo, target kal ka close. Kitna bada gap significant hai? ATR se compare karo: $R = |open - close|/ATR$ ; agar $R>1$ to gap serious hai. Aur fade karte time hamesha stop lagao (gap up fade me stop today high ke upar), risk-reward kam se kam 2 hona chahiye. High volume = Grip (hold), Low volume = Give (fill).

Test yourself — Trading Strategies

Connections