Gap Analysis
Understanding Gap Trading
Basics
Introduction
Price charts often have blank spaces known as gaps, which represent times when no shares were traded within a particular price range. Normally this occurs between the close of the market on one day and the next day’s open. There are two primary kinds of gaps – up gaps and down gaps.
For an up gap to form, the low price after the market closes must be higher than the high price of the previous day. Up gaps are generally considered bullish.
A down gap is just the opposite of an up gap; the high price after the market closes must be lower than the low price of the previous day. Down gaps are usually considered bearish.
Why they are formed?
Understanding Gaps
Gaps result from extraordinary buying or selling interest developing while the market is closed.
For example, if an earnings report with unexpectedly high earnings comes out after the market has closed for the day, a lot of buying interest will be generated overnight, resulting in an imbalance between supply and demand. When the market opens the next morning, the price of the stock rises in response to the increased demand from buyers.
If the price of the stock remains above the previous day’s high throughout the day, then an up gap is formed. Gaps can offer evidence that something important has happened to the fundamentals or the psychology of the crowd that accompanies this market movement.
Resistance Trendline
Types of Gaps
Gaps can be subdivided into four basic categories: Common, Breakaway, Runaway, and Exhaustion.
Common Gaps: Sometimes referred to as a trading gap or an area gap, the common gap is usually uneventful.
In fact, they can be caused by a stock going ex-dividend when the trading volume is low.
These gaps are common (get it?) and usually get filled fairly quickly. “Getting filled” means that the price action at a later time (a few days to a few weeks) usually retraces at the least to the last day before the gap.
This is also known as closing the gap. Here is a chart of two common gaps that have been filled. Notice how, following the gap, the prices have come down to at least the beginning of the gap; this is called closing or filling the gap.
- A common gap usually appears in a trading range or congestion area, where it reinforces the apparent lack of interest in the stock at that time. This is often further exacerbated by low trading volume. Being aware of these types of gaps is good, but it’s doubtful that they will produce trading opportunities.
Breakaway Gaps: Breakaway gaps are the exciting ones. These occur when the price action is breaking out of a trading range or congestion area.
To understand gaps, one has to understand the nature of congestion areas in the market.
A congestion area is just a price range in which the market has traded for some period of time, usually a few weeks or so.
The area near the top of the congestion area is usually resistance when approached from below. Likewise, the area near the bottom of the congestion area is support when approached from above.
To break out of these areas requires market enthusiasm, and either many more buyers than sellers for upside breakouts or many more sellers than buyers for downside breakouts.
- A good confirmation for trading gaps is whether or not they are associated with classic chart patterns. For example, if an ascending triangle suddenly has a breakout gap to the upside, this can be a much better trade than a breakaway gap without a good chart pattern associated with it.
- The chart below shows the normally bullish ascending triangle (flat top and rising, lower trend line) with a breakaway gap to the upside, as you would expect with an ascending triangle.
Runaway gaps: Runaway gaps are best described as gaps caused by increased interest in the stock. Runaway gaps to the upside typically represent traders who did not get in during the initial move of the up trend and, while waiting for a retracement in price, decided it was not going to happen.
Increased buying interest happens all of a sudden, and the price gaps above the previous day’s close. This type of runaway gap represents a near-panic state in traders. Also, a good uptrend can have runaway gaps caused by significant news events that cause new interest in the stock.
In the chart below, note the significant increase in volume during and after the runaway gap.
- Runaway gaps can also happen in downtrends. This usually represents increased liquidation of that stock by traders and buyers who are standing on the sidelines. These can become very serious as those who are holding onto the stock will eventually panic and sell – but sell to whom? The price has to continue to drop and gap down to find buyers. Not a good situation.
Exhaustion gaps: Exhaustion gaps are those that happen near the end of a good up- or downtrend. They are often the first signal of the end of that move.
They are identified by high volume and a large price difference between the previous day’s close and the new opening price.
They can easily be mistaken for runaway gaps if one does not notice the exceptionally high volume.
- It is almost a state of panic if the gap appears during a long down move where pessimism has set in. Selling all positions to liquidate holdings in the market is not uncommon. Exhaustion gaps are quickly filled as prices reverse their trend.
- Likewise, if they happen during a bull move, some bullish euphoria overcomes trades, and buyers cannot get enough of that stock.
- The prices gap up with huge volume; then, there is great profit taking and the demand for the stock totally dries up.