Gaps and Gap Analysis
Learn about different types of gaps, their significance in market trends, and how to effectively incorporate gap analysis into your trading strategy.
Last updated
Was this helpful?
Learn about different types of gaps, their significance in market trends, and how to effectively incorporate gap analysis into your trading strategy.
Last updated
Was this helpful?
Price charts often have blank spaces known as gaps, representing times when no shares were traded within a particular price range. Usually this occurs between the market close and the next trading 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 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.
Gaps result from extraordinary buying or selling interests often developing while the market is closed. For example, if an unexpectedly strong earnings report comes out after the market has closed, a lot of buying interest will be generated overnight. This results in an imbalance between supply and demand. So, when the market opens the next morning, the stock price rises in response to the increased demand from buyers. If the stock price 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 psychology of the crowd that accompanies the price movement.
Up and down gaps can form on daily, weekly, or monthly charts and are considered significant when accompanied by above average volume.
Gaps appear more frequently on daily charts—every day presents an opportunity to create an opening gap. Gaps on weekly or monthly charts are rare. If you're looking at a weekly chart, the gap would have to occur between Friday's close and Monday's open. If you're looking at a monthly chart, the gap would have to be between the last day of the month's close and the first day of the next month's open for monthly charts.
A price chart with gaps that occur almost daily is typical for thinly-traded securities and should probably be avoided. Prices often gap up or down at market open, but the gap does not last until the market closes. Such temporary intraday gaps should not be considered as having any more significance than normal market volatility.
Gaps can be subdivided into four basic categories:
Common Gaps
Breakaway Gaps
Runaway Gaps, and
Exhaustion Gaps
This type of gap is sometimes referred to as a trading gap or an area gap. Common gaps are usually uneventful. 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. Below is a chart of three common gaps that have been filled. Notice how, following each gap, the price retraced to where the gap started. In other words, the gap has been filled.
A common gap usually appears in a trading range or congestion area, reinforcing the apparent lack of interest in the stock. 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 are exciting. These occur when the price action is breaking out of a trading range or congestion area. To understand gaps, you have to understand the nature of congestion areas in the market.
A congestion area is a price range in which the market has traded for some time, usually a few weeks or so. The area near the top of the congestion area is usually a resistance area when approached from below. Likewise, the area near the bottom of the congestion area is a support area 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.
Volume will (should) pick up significantly from the increased enthusiasm and also because many are holding positions on the wrong side of the breakout and will need to cover or sell them. It's better if the increase in volume happens after the gap occurs. This means that the new change in market direction has a chance of continuing. The point of the breakout now becomes the new support (if it's an upside breakout) or resistance (if it's a downside breakout). Avoid falling into the trap of thinking this type of gap, if associated with good volume, will be filled soon. It might take a long time for the gap to be filled. Instead, go with the thought that a new trend in the direction of the stock has taken place and trade accordingly.
Notice in the chart below how prices spent a few weeks consolidating. Prices broke above resistance at low volume and pulled back. The following breakaway gap took place with high volume, indicating a significant bullish shift in sentiment and triggering the start of a new uptrend.
Price gaps associated with classic chart patterns tend to be stronger than those that aren't. For example, an ascending triangle with a breakaway gap to the upside can be a much better trade than a breakaway gap without a good chart pattern.
Runaway gaps are best described as gaps caused by increased interest in the stock. Runaway gaps to the upside typically represent traders who didn't get in during the initial move of the up trend and, while waiting for a retracement in price, decided it would not happen. Increased buying interest happens suddenly, 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 stock liquidation by traders and buyers standing on the sidelines. Those holding 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.
The term measuring gap is also used for runaway gaps. It isn't easy to find examples for this interpretation, but it's a way to help decide how much longer a trend will last. The theory is that the measuring gap will occur in the middle of, or halfway through, the move.
Sometimes, the futures market will have runaway gaps caused by trading limits imposed by the exchanges. Getting caught on the wrong side of the trend when you have these limit moves in futures can be horrifying. The good news is that you can also be on the right side of the trend. These are not common occurrences in the futures market, despite all the wrong information being touted by those who don't understand it (and are only repeating something they read from an uninformed reporter).
Exhaustion gaps happen near the end of a good up or downtrend. The gaps are often the first signal of the end of that move. They're 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 you overlook 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 dries up. Prices drop, and a significant change in trend occurs (see chart below for an example of an exhaustion gap).
After the stock price jumped, it lost momentum, as bulls might have suspected that price was overvalued. This sentiment continued for two weeks, after which prices resumed trending upward.
Price gaps can be crucial indicators of shifts in trading activity. Gaps provide valuable insights into market sentiment and potential trading opportunities. Recognizing and understanding the different types of gaps can be an invaluable asset for traders at all levels. Each type signifies different market conditions, with implications for strategy and risk management.
The adage that all gaps eventually get filled might not always hold true, especially in the case of Breakaway and Runaway gaps. Waiting for breakout or runaway gaps to be filled can devastate your portfolio. Similarly, waiting for prices to fill a gap before getting on board a trend might make you miss a big move. So, instead of waiting for gaps to be filled, you may be better off focusing on the message gaps convey about market dynamics. Gaps are a significant technical development in price action and chart analysis. Japanese candlestick analysis is filled with patterns that rely on gaps to fulfill their objectives.
