There are times when a market is trading at low volume and within a wide range. The market may show clear areas of support and resistance. The one thing that is lacking is any indication of a possible trend.

Despite the low volume, or perhaps because of it, there may be frequent trading gaps on the chart.  You check the volume indicator and notice that no significant volume seems to be driving it. You check the fundamentals; nothing significant seems to be driving them.

 

Common Gaps Within a Trading Range

These are called “common gaps,” and they are often driven by short-term sentiment in a low-volume environment. News may trigger them, or a larger set of positions pre-market may also trigger them. But common gaps rarely follow through, and most of them occur within a wider range of support and resistance, meaning they are often not breakouts.

 

Fading a Common Gap is a Risky Short-Term Tactic

It seemingly makes sense that if nothing significant is fundamentally driving a gap, and if the gap is neither a breakout nor a “breakdown” (downward breakout) from resistance or support, and if you forecast the back-and-forth trading range to continue, then, you might ask yourself, “why not fade the gap to its pre-gap levels?”

Well, it’s easier said than done. While you might have a clear profit objective–fading it the gap until the security reaches its pre-gap level–what is not clear is how far the security may continue to move in the direction of the gap before it reverses. Hence, it is unclear as to where you might favorably place your stop loss.

 

Example: Fading the Common Gaps in SGOL (Physical Swiss Gold Shares) ETF

From January 24 to April 16, 2018, gold traded in a wide range. SGOL, and ETF that tracks the price of gold, but whose average trading volume is relatively low, was subject to price gaps during this time. Not only was gold in general experiencing a decrease in trading volume, but SGOL’s lower volume profile accentuated that decrease in the form of more disconnected gaps between trading days.

We saw 12 common gaps, all of which fell within support and resistance, most of which had relatively low or decreasing volume, most of which were “tradable” for those looking to fade, and most of which were potentially profitable but high-risk trades.

 

common-gaps-SGOL-300x165 Fading Common Gaps - A Risky Proposition

 

Let’s go through each trade and examine the potential risks and outcomes. We’ll compare the trades that returned to pre-gap levels (potentially profitable) from those that did not (loss).

The main risk in each trade can be stated in this way: where would you have placed your stop loss, and how many sessions might you have waited before closing a losing trade or getting stopped out?

  • Trade 1: returned to pre-gap levels on the following session
  • Trade 2: loss
  • Trade 3: loss
  • Trade 4: returned to pre-gap levels
  • Trade 5: returned to pre-gap levels OR loss depending on your risk and duration
  • Trade 6: loss
  • Trade 7: returned to pre-gap levels OR loss
  • Trade 8: returned to pre-gap levels OR loss
  • Trade 9: returned to pre-gap levels
  • Trade 10: returned to pre-gap levels
  • Trade 11:  returned to pre-gap levels
  • Trade12:  returned to pre-gap levels

Outcome:

Six potential winning trades.

Three losing trades.

Three trades that may have been winners or losers.

 

In the end, the outcome of such a strategy cannot easily be determined. And although in most of the cases in the above example, price within the large trading range “re-covered” their common gaps, you can see the indeterminate risks that a trader would have had to face while attempting to gain a profit from this strategy.

 


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