How to Use Options to Capitalize on Market Gaps and Breakouts

When a tradable security opens much lower or higher than its previous closing price, a market gap occurs, creating notable spaces on the price charts. Market breakouts are another phenomenon that happens when the stock price crosses a significant resistance level and signals a potential trend shift. The reasons we are pointing out these discrepancies in the market is because gaps and breakouts present unique opportunities for options traders who can take advantage of these price movements with controlled risk.

This comprehensive guide on gaps and breakouts will outline the best trading strategies and techniques for securing profits around these market events. Along with the opportunities that are out there, you’ll find some risks for trading around gaps and breakouts, so we’ve highlighted those risks and the best ways to navigate them. Our guide also has some real-world examples to give you some decent illustrations of how to trade successfully when dealing with market gaps or breakouts.  

Understanding Market Gaps and Breakouts

Market gaps and breakouts present trades with unique opportunities to lock in a profit, but some traders with little experience might not be aware of when gaps and breakouts occur and how to navigate them in a way to maximize profit potential. 

What Are Market Gaps?

Market gaps in options trading are when there’s a noticeable space on the price chart. A security will jump considerably higher or lower in between trading sessions. It results in a chart that has a black area which shows that no trades occurred within that price range. Market gaps commonly occur when a security’s opening price is very different from the previous closing price. Market gaps usually happen when there are major shifts in market sentiment or when there are major news events. 

Types of Gaps

Why Gaps Occur 

When there’s a considerable price difference between the closing price of a trading session and the opening price of the next trading session, gaps occur and they’re typically triggered by market shifts that might occur suddenly due to news like earnings releases or other significant macroeconomic events. There are even times where gaps occur due to small news or seemingly insignificant events like periods of low trading volume. Due to these smaller factors, large gaps and price swings can occur. 

What Are Market Breakouts?

Market breakouts are the result of a stock or commodity’s price breaking through support or resistance levels, which gives signals to traders to either buy or sell the stock or commodity. Market breakouts can also be super helpful in pinpointing trends or shifts in momentum within the broader market. 

Traders can find market breakouts by carefully analyzing price movements and market trends. Monitoring price and volume as well as looking for stocks that have strong support or resistance levels are a few other keys to identifying market breakouts. Companies that have a competitive advantage are notable for influencing breakouts in the options trading market. It’s important to note that there are some significant risks to trading around market breakouts. For instance, overleveraging can magnify losses or gains. Chasing these kinds of trading opportunities can also lead traders to increased risk exposure. 

False breakouts occur when the prices move out of a support or resistance level, but then quickly reverse course. These false breakouts can give traders clues that the price might be changing in the opposite direction, but they can also trap traders into losing investments. 

You can avoid false breakouts using the following strategies:

• Use alerts to your advantage. Traders using alerts can be notified and kept in the loop on the market conditions needed to identify a potential false breakout. 
• Be aware of the timeframes and chart patterns associated with false breakouts. This comes with time studying the market conditions and knowing the primary signs of a break that fails to catch.  
• Another useful tool to avoiding false breakouts is using candlestick charts where the strength of a breakout can be confirmed when the candle closes. 

Common Breakout Patterns

If you’re wondering how to spot a breakout pattern on the price charts, we’ve outlined the most common ways that these breakouts will show up in the data. There are three common patterns that are worth knowing and strongly suggest a breakout is imminent. 

Why Use Options to Trade Gaps and Breakouts?

This process trading options around gaps and breakouts involves strategically buying or selling contracts when the stock price experiences significant price increases or decreases. Using options is best under these circumstances because they provide traders with a great deal of flexibility and leverage. 

• Leverage: When traders take on larger positions based on these price movements, they can control a large position with a relatively small amount of capital. This can lead them to enjoy large gains when the gap or breakout occurs. It also comes with some risks including the possibility of incurring larger losses too. 
• Defined Risk: Trading around gaps and breakouts typically involves trading strategies where traders can set their own stop-loss or take-profit orders, effectively limiting the downside risk associated with the trades. 
• Flexibility: Using options, traders can turn a profit from both upward and downward movements, which means they can make money if the market is in a downturn or if their prediction of the market direction is incorrect. 
• Hedging: Protect against adverse moves or reduce directional risk through the use of hedging positions with options. 

Best Options Strategies for Trading Gaps and Breakouts

If you’re curious about the best trading strategies and techniques for navigating market gaps or breakouts and securing a profit along the way, you need to check out the following strategies where we cover when to use them, how to select the best strike prices and expiration dates, and examples of how they might work out in real life. 

Buying Call Options for Bullish Breakouts

Buying call options is a bullish strategy which involves buying the right to buy a stock at a certain strike price and by a certain expiration date, which can be used to profit if the stock price rises above the strike price within that given time frame. 

When to Use

Since the price moves above a resistance level accompanied by high volume when a bullish breakout occurs, these are the ideal conditions for traders to begin buying call options. The market is signallying the momentum toward bullish trends and it’s predicted that the price may continue to rise further. It’s preferable for traders to buy call options because these conditions are showing that buying pressure is beginning to overcome selling pressure at a key resistance point.

Strike Price Selection

It’s recommended for traders to choose strike prices that are either near-the-money (ATM) or slightly out-of-the-money (OTM) calls. With near-the-money strikes, the traders only need to see the underlying asset experience a small movement to experience a profit. Slightly out-of-the-money strikes are beneficial in these circumstances because there’s a good chance of securing a profit while also allowing for a greater amount of leverage with a smaller initial investment.

Expiry Considerations

It’s generally best for traders to select shorter expiration dates on these call options, some of the best being weekly or near-term monthly expirations. However, the choice comes down to the trader and their style, appetite for risk, and the dynamics at play in the market. Short-term expiries, for example, are good for aggressive moves, but some traders might prefer longer-term expiries for sustained breakouts.

Example Scenario

Suppose there’s a scenario where the stock gaps up after earnings and breaks a key resistance level of $50. The best move for the trader would be to buy a $50 or $52.50 call option to take advantage of this bullish breakout. Traders should also use an ATM or slightly OTM strike, along with a shorter expiration date to make the most of the trade.

Buying Put Options for Bearish Breakouts

Buying put options is a bearish strategy that involves buying the right to sell a stock at a certain strike price and by a certain expiration date, which can be used to profit if the stock price falls below the strike price within that given time frame. 

When to Use

When the selling force in the market becomes dominant to the point where buyers can’t maintain the price at that level, the price breaks below support on strong selling pressure, which is a good time to buy put options around the event of a bearish breakout. Once the sellers take control, the price of the stocks is driven down further and the previous support level (broken by the sellers) becomes the new resistance point.

Strike Price Selection

Traders will want to choose a strike price that is at-the-money (ATM) or slightly in the money (ITM) for optimal risk and reward. ATM strikes are the same amount as the current market price which means there’s no intrinsic value, but it does hold value from time decay until the expiration date hits. ITM strikes are only slightly higher or lower than the current market price. Each of these strikes reflects bearish sentiment which aligns with the strategy of buying put options around a bearish breakout.

Expiry Consideration

Traders will benefit greatly from choosing a shorter expiration date around a bearish breakout. During these conditions, the price is expected to fall quickly, so choosing a short-term expiry is great for securing a profit during a quick decline. Going with a shorter expiration date also works in the trader’s favor due to time decay if the price falls quickly, which increases the potential profits.

Example Scenario

For this example, let’s look at a hypothetical situation where the stock breaks down below the key support at $100. The trader would do well to buy a $100 put to take advantage of the bearish breakout by making a move that will profit off the decline of the stock price. They need to choose an ATM or slightly ITM strike and a shorter expiration date for optimum effect.

Using Debit Spreads for Controlled Risk

This strategy is where traders buy one option with a higher premium and sell another with a lower premium at the same time. What makes the move a “debit spread” is the net outflow of cash where the traders are paying more for the option that they buy and then get for the option they sell. 

Bull Call Spread for Bullish Breakouts

In this scenario, traders are expecting a moderate price increase in the underlying asset, so they buy a call option with a lower strike price while also selling a call option with a higher strike price. The bull call spread involves buying an ATM call and selling a higher strike call. When traders use bull call spreads for bullish breakouts, they can offset some of the cost of buying the lower strike call when they sell a higher strike call option. It’s a strategy that’s ideal for sustained uptrends.

Bear Put Spread for Bearish Breakouts

Traders can take advantage of a moderate stock price decline and trade around it to profit from anticipated significant downward movements following a price surge. They do this by buying a put option at a higher strike price while at the same time selling a put option at a lower strike price. The traders become profitable when there’s a price drop and their higher potential loss is limited to the net premium they paid on the trade. All told, the bear put spread is a great strategy for traders who are expecting a controlled downtrend and want to execute a trade that comes with a defined risk.

Selling Credit Spreads to Capitalize on False Breakouts

Credit spreads refer to traders selling options with higher premiums and buying options with a lower premium, gaining a net credit in the process. The goal of a credit spread is to profit from underlying asset price movements. These are good strategies to use during false breakouts because they work if the price fails to hold above the resistance level. 

Bear Call Spread for Fake Bullish Breakouts

When fake bullish breakouts occur, traders could benefit from doing a “bear call spread” which is selling an OTM call and buying a further OTM call. It’s best used when the trader expects the price of the underlying asset to either remain stable or decline. The result is that the trader can lock in a profit from the premium they get for selling the lower strike call option. At the same time, this move can help them limit losses if the price goes up considerably.

Example: A false breakout occurs when stocks break above $200 but quickly reverse. The trader can set up a bear call spread by selling a $210 call and buying a $215 call to profit when the price fails to hold above resistance.

Bull Put Spread for Fake Bearish Breakouts

In the case of a fake bearish breakout, the trader can sell an OTM put and buy a lower OTM put. Bull put spreads are effective in the case where the price fakes a breakdown but reverses higher.

The trader would sell a put option at a higher strike price and buy a put option with a lower strike price, all at the same time. Each part of the bull put spread would have the same expiration dates and involve the same underlying asset. The strategy profits when there’s a moderate rise in the stock price, in addition to the trader collecting a net credit upfront which helps to limit potential losses.

Trading Gaps with Straddles and Strangles

Straddles and strangles are trading strategies where you can realize a profit as long as there’s market volatility. You don’t have to correctly predict which ways the markets are heading and you can still profit as long as conditions remain volatile. 

Long Straddle

Traders buy a call and put option with the same expiration date and strike price. It’s best used when the trade expects the stock to make a big move outside of its usual trading range, basically when volatility is expected to increase. The trader will ultimately profit if the stock prices rise or fall considerably with the maximum loss being the premium the trader paid to enter the trade.

The long straddle is a good move around gaps because it’s best for high-volatility events where the direction is uncertain. A great example of using the long straddle in these circumstances would be following an earnings announcement with a large implied move, resulting in a gap.

Long Strangle

A cheaper alternative to straddling, the long strangle requires a more significant move. This move involves the trader buying an out-of-the-money call and put option at the same time which have the same expiration date but different strike prices. The long strangle is ideal to use when you’re expecting a major reaction but unsure of the direction or when you expect the underlying stock to be highly volatile.

People tend to like the long straddle for its lower level of risk and its high payoff potential. Losses are limited to the premium paid for the position and the maximum profit is technically unlimited on the upside. 

Using Iron Condors for Range-Bound Markets After Gaps

Working an iron condor into your trading routine following gaps within range-bound markets is preferable because it lets traders create a profit from price stability which occurs within a defined range. Selling a call and put option can lead to profit even if the stock has experienced some significant price movement in either direction. One of the main advantages of the iron condor is having a defined risk profile where the max profit is the premium collected at the onset of the trade and the max loss is limited to the differences between the short and long strike prices.   

Selling an iron condor is a move where traders can profit from time decay. By selling an out-of-the-money call and put options at different strike prices, traders can make money if the price of the underlying asset remains stable and within a defined range. 

Risk Management & Key Considerations

When traders are looking to take advantage of trading around market gaps and breakouts, there are several key considerations including some primary risk management techniques for maximizing potential profit and minimizing potential losses. We’ll address these methods for managing risk around the possible gaps or breakouts that’ll occur around significant market events like earnings reports or noteworthy news.  

• Avoiding False Breakouts: Getting around failed breakouts is one of the primary risk management methods in this scenario. Look for confirmation through technical indicators like volume, price action, or the relative strength Index (RSI). You’ll have to deal with false breakouts from time to time, but if you have enough foresight to spot one ahead of time and avoid it altogether, you’ll be managing your risk much better. 
• Managing Implied Volatility: Be aware of IV crush post-earnings or news events. This occurs when there’s anticipation of volatility before a major event, causing traders to increase the price of options. Traders who buy up a ton of these options could be hung with them if the value significantly decreases following the event. Longer-dated and ATM options are particularly susceptible to IV crush. 
• Setting Stop-Losses & Exits: Traders will do well to define the maximum risk they’re willing to take on per trade. Using technical analysis tools, traders can figure out the ideal places to enter or exit a position. Setting up stop losses is a great way to limit potential losses. When the trader selects the maximum amount they’re willing to lose on the trade, the stop loss order will automatically execute a trade at that desired level to keep losses from getting too out of control. 
• Position Sizing: Each trader needs to take the time to evaluate their personal risk tolerance, or how much money they’re willing to lose to secure a larger profit. Once this has been established, traders must determine a position size for each trade. 1% of your total capital allocated to a single position is good for more conservative traders, while 2% is a respectable level for those who are more aggressive. 

Real-World Examples of Trading Gaps & Breakouts with Options

We’ve talked quite a bit about gaps and breakouts in options trading, but what do they look like in the real world? For your convenience, here are some real-world examples of how trades structured around these market events could play out for the traders involved. 

Case Study 1

Let’s look at a trading strategy where the trader buys call options on a stock that is expected to experience a big price jump. Another way you could refer to this move would be “trading call options around earnings gaps.” 

This example will focus on executing this move with Netflix stock following a breakout that occurs after the release of their earnings announcement. Netflix released a report that was more positive than investors were originally expecting. Buying call options on the stock allows the trader to bet on the stock price rapidly increasing after the announcement. Traders can then profit from the option’s higher value which was made possible by the price gap that was created. 

Case Study 2

Let’s look at another example involving a Tesla stock that fails to break out. This could be referred to as a “false breakout” and a good way to deal with this situation is to use a credit spread. Traders must sell a call option at a slightly higher strike price while also buying a further out-of-the-money option at a lower strike price. By doing so, they can collect a premium (or a net credit) from the trade. 

The reason a trader would do a credit spread when the Tesla stocks fails to breakout would be because they are expecting the price to quickly reverse back into the previous range. The credit spread would let them profit from time decay. The market is slowly fading the false breakout and the Tesla option prices are retracting back into the range they were previously in before the expected breakout. 

Case Study 3

For this illustration, let’s say that there’s an announcement coming up from the Federal Open Market Committee (FOMC). Straddles are a good trading strategy to use around events like this because they profit from market volatility.

In this scenario, the trader would buy a call and put an option on the same stock with the same strike price and expiration date. They would do this before the announcement because you’re betting on there being a major price swing in either direction. Choose a strike price that’s at the money (ATM) or close to the current stock price. The expiration date should be set for around the time of the announcement to capture the most amount of volatility, and to lock in a profit. 

Turn Market Gaps into Profitable Opportunities

If you’re looking for profitable opportunities for trading options online around market gaps and breakouts, keep these techniques and strategies in mind for these specific market events. 

• Buying Call Options—Best for Bullish Breakouts
• Buying Put Options—Best for Bearish Breakouts
• Using Debit Spreads—Best for Controlled Risks 
• Selling Credit Spreads—Capitalize on False Breakouts
• Strangles and Straddles—Best for Trading Gaps
• Iron Condors—Use For Range-Bound Markets After Gaps

Options are a great tool for trading market gaps and breakouts because there are multiple ways where traders can lock in a profit, no matter what the condition of the market may be.  If you’re new to trading options or want to get more familiar with trading around gaps or breakouts, it’s best to practice these strategies with a demo account before using real capital.

Check out all of our trading guides and tools at OptionsTrading.org.

Frequently Asked Questions—Trading Market Gaps & Breakouts with Options 

Check out some of the most popular and common questions from our customers and readers about market gaps and breakouts. We’ve taken the time to answer these questions and included them in this section to give you an idea of the 

How do I know if a breakout is real or fake?

When there’s a false breakout, the price breaks the level but it quickly reverses and goes back inside the range. Real breakouts happen but the price stays above the breakout level and continues moving in the primary breakout direction. 

What is the best time frame to trade breakouts with options?

Intra-day traders will have the best success with timeframes of five minutes or fifteen minutes. The next level up would be swing traders and they would ideally need a timeframe of one to four hours for optimum success. Anyone who is a positional trader will benefit greatly from break trading which occurs using daily or weekly charts. 

Should I buy options before or after an earnings gap?

The best course of action is for traders to buy the option contract a few days before the earnings announcement is set to take place. The trader must sell the contract on the day of the release of the earning report. Holding options until the expiration date isn’t necessary because the main movements for the stock price occur on the day of the announcement.

What’s the biggest risk when trading gaps with options?

The biggest risk that a trader will run when trading gaps with options is the likelihood of whether or not the gap will be filled at all. These gaps must be filled quickly enough, so traders can secure a profit for themselves. When news events or unexpected market volatility set in, this can create a scenario where traders will incur losses due to the gap remaining open. 

How do I adjust my trade if the market moves against me?

There are several ways that traders can adjust their positions to navigate an unfavorable market movement including setting up stop-loss orders to mitigate potential risks or to close out the position altogether if the market conditions are going against your original predictions.