I will talk about what types of commons gaps traders are likely to see. Then, I will move on to the more important subject of how to profit from gaps.

Types of Gaps

Continuation gaps occur during powerful trends. In a bull trend, the stock is moving upwards strongly and then gaps up. In a bear trend, the stock gaps down while already in a powerful down trend. These trends are confirmed when you see volume spike by 50 percent or more on the gap up.

Breakaway gaps: These occur when a stock is in a base and then gaps up or down as it begins a new powerful trend. The longer the base, the longer the new trends tend to last. These trends can last anywhere from weeks to years. Usually the volume on the day of the gap is much higher than usual and often times, it persists for several days. These gaps represent a mass change in the sentiment on the stock.

Common Gaps: Most gaps are common gaps. Common gaps are short-lived and the prices reverts to close the gaps relatively quickly, usually within the next few days after the gap. Volume tends to remain average during common gaps. There is really nothing extraordinary or powerful about common gaps. Usually, they are not tradable.

Exhaustion Gaps: Exhaustion gaps are so named because they occur at the end of trends. The difference between exhaustion gaps and continuation gaps is that exhaustion gaps are typically not accompanied by the higher highs that you see in continuation gaps. You can confirm an exhaustion gap when you see prices reverse in the opposite direction of the gap thus closing the gap. Once you see prices return back to their orginal levels before the gap, it's time to exit the position.

How to Profit

The most effective way to profit using options on gaps is to buy or sell short on breakaway gaps. These are the most effective setups because they have the most potential to trend powerfully (enough to double the value of your options). An effective risk control method is to set a stop right at the price of the stock before gape. IF the stocks gapped down 40% on a bear trade, this is obviously not going to work, but if the gap is smaller (like 3-4%) this may be an effective place to set a stop for your position. The best setups occur after a long base or trading range has been in place for a multi month, or mult-year period. If you are trading a continuation or breakaway gape, it is imperative that the stock continue to make higher highs in a bull trade and lower low's in a bear trade. Otherwise, what looked like a continuation or breakaway gap may actually be an exhaustion gap.

Another strategy to look for is trading the exhaustion gaps. They should be traded in the same manner as the other strategies described above in terms of setting stops. Many exhaustion gaps are accompanied by very strong reversals which can produce significant profits. The most common type of gap is the common gap.

Sell Strategies

What about when to exit? An outstanding sell strategy is to look at the vertical distance that the stock traveled preceding the gap. Stocks often can cover the same distance right after a gap. Use this strategy with continuation gaps and breakaways gaps. In conclusion, gaps offer unique opportunities for traders who can handle the high-risk nature of these trades. Gaps tend to be followed up with much higher levels of volatility. The key here once again is to develop a well-defined, tested, repeatable strategy. Develop yours.

Price Headley is the founder and chief analyst of BigTrends.com.