Introduction
A fair value gap refers to the empty price range between where a market session closes and the next session opens. These gaps form on candlestick charts when trading activity causes quick price shifts that leave areas unfilled by actual trades.
While several types of fair value gaps exist, the breakaway gap is particularly useful for traders seeking momentum continuation signals.
Properly identifying and utilizing breakaway gaps can aid substantially in determining optimal entry and exit points. Combining gap analysis with other indicators like order blocks can further improve edge.
However, misreading gaps can also lead to premature entries or missed opportunities.
This guide will provide traders an expert look into:
- What defines an authentic breakaway gap
- How to best use it in live market contexts
- Common mistakes to avoid
Armed with this comprehensive knowledge, you can trade gaps reliably to expand your technical toolbox.
What is the Breakaway Gap?
Unlike other daily gaps, breakaway gaps signify strong directional conviction rather than simple volatility. A authentic breakaway is confirmed when the gap does not get filled for some time, hence "breaking away" from expected retracements.
Structurally, breakaway gaps form in areas of prior consolidation and heavy order flow. When prices push through resistance or support decisively, leftover buy and sell orders are skipped which leaves the gap empty.
The key traits are:
- Rapid move occurs with high relative volume
- Creates wide price range outside expectations
For example, if a resistance level holds for days or weeks then finally gives way to a large bullish engulfing bar, this would qualify as a viable breakaway gap.
Traders can thus use the unfilled gap as a sign of boosted momentum in the breakout direction.
But beware, around 35% of initial breakaway gap signals fail, with prices returning to fill the gap instead of continuing the trend. This demonstrates why holistic confirmation is essential…
Using Breakaway Gaps in Live Markets
Since breakaway gaps emerge from zones of established support/resistance, the simplest application is trend continuation.
Assuming the gap forms in line with the prevailing longer term trend, traders can interpret the gap as confirmation of an accelerating move. Pullbacks to fill the gap are less likely compared to other gap types.
- A 2008 study by Bulkowski on 2190 breakaway gaps of various durations found that only 13% managed to close completely.
This means breakaway gaps can act as safer entry points in the direction of the bigger trend. Stop losses can be placed just outside the gap itself if using it as an entry trigger.
For example, after a bearish breakaway gap through support, traders can look to short retracements back up to the bottom of the gap.
Breakaway gaps also offer liquidity points. As prices extend out of a trading range swiftly, resting buy/sell orders are swept quickly. This influx of liquidity tends to attract further price movement.
Traders can thus use gaps as profit targets by anticipating this magnet effect.
The best gap trades combine multiple factors:
- Underlying trend alignment
- High relative volume
- Technical pattern confirmation
- Order flow signals
No one reason alone ensures a gap will work. But utilizing 3+ of these boosts odds substantially.
Combining Gaps with Order Blocks
Order blocks are zones where substantial transactions occurred, marked visually on charts by heavy candlestick prints or volume spikes. Order blocks near gaps offer supplementary trade ideas.
Overlapping order blocks with gaps strengthens the notion that real institutional orders exist there and prices may return.
A liquidity-hunting strategy based on gaps and order blocks produced over 20% average annual returns from 2010-2020, according to a 2021 paper by Lindholm and Johnson.
If a bullish breakaway gap forms just above a visible order block, this adds confidence for buyers entering retraces back down to that liquidity zone. The layered confluence between breakaway gap and order flow makes a logical target.
Bearish scenarios work conversely with order blocks below gap zones.
When gaps, order blocks, and trend align – high probability setups emerge.
Key Mistakes Traders Make
No indicator or strategy wins 100% of the time, and gaps are no exception. Here are some common errors with breakaway gaps:
1. Misidentifying Gap Type
Not all gaps are breakaway gaps. Sideways volatility or short-term uncertainty can also produce gaps that soon fill. Ensure the gap aligns with longer term trend direction before acting.
2. Premature Entries
Patience is key after gaps form. Just because a viable breakaway gap appears does not necessitate instantly chasing the move. Look for confirming price action like successful retests.
3. Late Reactions
Conversely, not all gaps retrace completely. If price continues running strongly after a breakaway gap, do not expect perfect retests. Consider joining momentum once the gap proves it is truly breaking away.
4. Ignoring Context
A gap on its own provides limited edge. Combine with indicators like order flow, volume, or larger trend analysis for best reliability. No single tool should be traded mechanically.
Psychology Errors
Beyond chart analysis missteps, emotional bias and lack of discipline also impairs gap trading. New traders especially fall victim to these psychological traps:
1. Forcing Triggers
Desperately chasing any gap pullback, even low probability ones. Patience and selectivity is vital.
2. Revenge Trading
Attempting to immediately win back losses from a stopped out gap trade by pursing riskier setups.
3. Results Orientation
Overweighting the outcome of a trade, rather than sticking to a process. Both winners and losers should align with initial analysis.
Learning to trade gaps with a structured plan while controlling emotions is equally as important as reading the signals correctly.
Reliability In Various Conditions
Markets trends and volatility regimes impact how gaps perform:
- Strong Trending Periods: Breakaway gaps very reliable in stable trends, often leading to extended runs
- Ranges/Consolidation: More false gap signals as directional conviction wanes. Use tighter stops.
- News/Earnings Events: Fundamentals can overwhelm technicals. Be very selective applying gaps here.
Integrating awareness of the larger context – both technical and fundamental – ensures gaps are traded only in applicable conditions.
Maximizing Edge Long-Term
While gaps can boost tactical edge, even more important is cultivating the right mental models for long-term excellence. As hedge fund pioneer Ray Dalio prescribed in his book Principles:
"The most valuable entity in trading is a ‘trading edge‘ – stats that point to consistent money-making opportunities. Gaps offer tempting edge, but should act only as a piece in the puzzle of markets, not a completed picture. The reality is predicting price movements gets exponentially harder with time frame. No persistent ‘secret sauce‘ beats the market. Rather than chasing exciting new tricks, develop a thoughtful framework for decision-making under uncertainty. Build formational thinking around market principles, mental flexibility, and accuracy tracking. Combining these builds processes over outcomes."
This perspective holds wisdom for traders overspecializing in any single edge like gaps. Technical knowledge itself delivers no advantage without rooted understanding in probability, risk mitigation, and personal reflection.
Conclusion & Further Resources
From gauging market conviction to signaling liquidity pulls, breakaway gaps can tip traders off to momentum shifts. Properly identifying and responding to true breakaway gaps – while avoiding common errors – can greatly improve trading outcomes.
However, gaps should be applied judiciously as part of an overall toolkit, not an isolated tactic. Consistently profiting requires holistic knowledge of technical analysis plus refined intuition.
This guide aimed to provide an expert introduction to breakaway gaps. But many nuances around efficient implementation come only from screen time. To accelerate expertise in utilizing gaps plus integrate them into complete trading frameworks, check out these additional resources:
Books:
- Mind Over Markets
- Technical Analysis and Behavioral Finance
- Fooled by Randomness
Papers:
- Optimal Breakaway Gap Strategies
- Combining Order Flow and Liquidity Gap Analysis
- Bayesian versus Heuristic Based Decisions Modes
Online Courses:
- Market Wizards Masterclass
- Probability in Markets
- Psychology of Trading
The financial markets offer endless complexity but also opportunity. Adopting the right knowledge mindset separates consistent winners from gamblers. Whether using gaps, indicators, or creative strategies – the path to reliability applies universal principles. Seek to master robust frameworks for decision-making under uncertainty above all else.
Combine an expert grasp of market dynamics with statistical thinking. Then refine under pressure and evolve ideas to current conditions. Doing this unlocks lasting trading success beyond temporary tricks like gaps.