Price charts often have blank spaces known as gaps, which represent times when no transactions took place 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. 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, then an up gap is formed. Gaps can offer evidence that something important has happened to the fundamentals or the psychology of the crowd. In the forex market, it is not uncommon for a report to generate so much buzz that it widens the bid and ask spread to a point where a significant gap can be seen. Gaps can also occur due to technical reason. For example, a stock breaking a new high in the current session may open higher in the next session, thus gapping up for technical reasons. So what are the common timeframes for gaps? Up and down gaps can form on daily, weekly or monthly charts, and are considered significant when are fueled with higher than average volume. Gaps appear more frequently on daily charts, where every day is an opportunity to create an opening gap. Gaps on weekly or monthly charts are fairly rare: the gap would have to occur between Friday’s close and Monday’s open for weekly charts, and between the last day of the month’s close and the first day of the next month’s open for monthly charts. Gaps can be classified into four groups: Common gaps, breakaway gaps, exhaustion gaps, continuation gaps. Let’s discuss each of these types.
First one, common gaps. A common gap is a price gap found on a price chart for an asset. These occasional gaps are brought by normal market forces. They are also referred to as a trading gap or an area gap. These gaps are usually get filled fairly quickly. “Getting filled” means that the price action at a later time, usually retraces at the last day before the gap. This is also known as closing the gap. Here is a chart of a common gap that has 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 intensified by low trading volume. Because common gaps are relatively small, normal and somewhat regular events in the price action of an asset, they tend to provide no real analytical insight. The second type, breakaway Gaps These occur when the price action is breaking out of a trading range or congestion area. A congestion area is a price range in which the market has traded for some period of time, usually a few day or weeks. 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. In order to break out of these areas, we need some market enthusiasm, and many more buyers than sellers for upside breakouts or many more sellers than buyers for downside breakouts.
Volume will and should pick up significantly, not only from the increased enthusiasm, but because many are holding positions on the wrong side of the breakout and need to cover or sell them. It is better if the increase in volume does not happen until 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 an upside breakout) or resistance (if a downside breakout). Usually, this type of gap, if associated with good volume, won’t be filled soon. So, filling a breakaway gap might take a long time. It’s better to go with the fact that a new trend in the direction of the stock has taken place, and trade in that direction, not against it. Notice in this example how prices spent a long period of time without going lower than this support level. When they did, it was with increased volume and a downward breakaway gap. 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. This example shows a bullish ascending triangle (with a flat top and rising and a lower trend line) with a breakaway gap to the upside, as you would expect with an ascending triangle.
Therefore, a breakaway gap shows decisive movement out of a range or other chart pattern. The volume plays an important role in this strategy. A breakaway gap with larger-than-average volume, or especially high volume, shows strong conviction in the gap direction. A volume increase on a breakout gap helps confirm that the price is likely to continue in the breakout direction. If the volume is low on a breakaway gap there is a greater chance of failure. A failed breakout occurs when the price gaps above resistance or below support but can’t sustain the price and moves back into the prior trading range. Next type: Runaway Gaps Runaway gaps are best described as gaps caused by increased interest in a stock. Runaway gaps to the upside typically represent traders who didn’t get in during the initial move of an uptrend 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. Also, a strong uptrend can have runaway gaps caused by significant news events that cause new interest in the stock. In this example, pay attention to the significant increase in volume during and after the runaway gap. Runaway gaps can also happen in downtrends. This usually represents increased selloff of that stock. This type of gap occurs during strong bull or bear moves, and is characterized by a significant price change in the direction of the prevailing trend. During a trend, a security’s price may experience several runaway gaps which can help to reinforce the trend’s direction. It’s not uncommon for runaway gaps to occur after a stock has experienced a breakaway gap.
Next type: Exhaustion Gaps Exhaustion gaps are those that happen near the end of a strong 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 you don’t notice the exceptionally high volume. An exhaustion gap is a technical signal marked by a break lower in prices that occurs after a rapid rise in a stock’s price. This signal reflects a significant shift from buying to selling activity that usually coincides with falling demand for a stock. The implication of the signal is that an upward trend may be about to end soon. In the case of an exhaustion gap, prices gap up with huge volume; then, there is a major profit taking and the demand for the stock totally dries up. Then prices drop, and a significant change in trend occurs. Exhaustion gaps are probably the easiest to trade and profit from. In this example, notice that there were several more days of trading to the upside before the stock plunged.
The high volume was the giveaway that this was going to be either an exhaustion gap or a runaway gap. Because of the size of the gap and the near tripling of volume, an exhaustion gap was more likely than a runaway one. There are many ways to take advantage of these gaps, with a few strategies more popular than others. This video was basically an introduction to gap trading combined with volume, but in the future we’ll go deeper and we’ll apply different strategies, using price action and indicators, to take advantage of gaps. As always, if you learned something new and found value, leave us a like to show your support, subscribe to our channel and hit the bell icon to stay in touch when we upload new videos. Until next time.