Have you ever wondered what causes gaps in price charts and what they mean? Well, you've come to the right place. Just in case, a gap is an area on a price chart in which there were no trades. Normally this occurs between the close of the market on one day and the next day's open. Lot's of things can cause this, such as an earnings report coming out after the stock market has closed for the day. If the earnings were significantly higher than expected, many investors might place buy orders for the next day. This could result in the price opening higher than the previous day's close. If the trading that day continues to trade above that point, a gap will exist in the price chart. Gaps can offer evidence that something important has happened to the fundamentals or the psychology of the crowd that accompanies this market movement. Before we get into the different types of gaps, here is a chart showing a gap so you will know what we are talking about.
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 for the monthly charts. Gaps can be subdivided into four basic categories: Common, Breakaway, Runaway, and Exhaustion.
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 (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 that after the gap the prices have come down to at least the beginning of the gap? That is called closing or filling the gap.
A common gap usually appears in a trading range or congestion area, and reinforces the apparent lack of interest in the stock at that time. Many times this is further exacerbated by low trading volume. Being aware of these types of gaps is good, but doubtful that they will produce a trading opportunities.
Breakaway gaps are the exciting ones. They occur when the price action is breaking out of their 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 more sellers than buyers for downside breakouts.
Volume will (should) pick up significantly, for not only the increased enthusiasm, but many are holding positions on the wrong side of the breakout and need to cover or sell them. It is better if the 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 breakout now becomes the new support (if an upside breakout) or resistance (if a downside breakout). Don't fall into the trap of thinking this type of gap, if associated with good volume, will be filled soon. It might take a long time. Go with the fact that a new trend in the direction of the stock has taken place, and trade accordingly. Notice in the chart below how prices spent over 2 months without going lower than about 41. When they did, it was with increased volume and a downward breakaway gap.
A good confirmation for trading gaps is if 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 are also called measuring gaps, and are best described as gaps that are caused by increased interest in the stock. For runaway gaps to the upside, it usually represents 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 an almost 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.
The term measuring gap is also used for runaway gaps. This is an interpretation that is hard to find examples for, but it is a way of helping one decide how much longer a trend will last. The theory is that the measuring gap will occur in the middle of, or half way through, the move.
Sometimes, the futures market will have runaway gaps that are 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 them. These are not common occurrences in the futures market despite all the wrong information being touted by those who do not understand it, and are only repeating something they read from an uninformed reporter.
Exhaustion gaps are those that happen near the end of a good up- or downtrend. They are many times the first signal of the end of that move. They are identified by high volume and 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. Prices drop, and a significant change in trend occurs. Exhaustion gaps are probably the easiest to trade and profit from. In the chart, notice that there was one more day 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 doubling of volume, an exhaustion gap was in the making here.
There is an old saying that the market abhors a vacuum and all gaps will be filled. While this may have some merit for common and exhaustion gaps, holding positions waiting for breakout or runaway gaps to be filled can be devastating to your portfolio. Likewise, waiting to get on-board a trend by waiting for prices to fill a gap can cause you to miss the big move. Gaps are a significant technical development in price action and chart analysis, and should not be ignored. Japanese candlestick analysis is filled with patterns that rely on gaps to fulfill their objectives.
Anyone who has ever looked at a price chart has more than likely seen a gap—an area on a price chart where there were no trades. On a daily price chart, this normally occurs between the close of the market one day and the next day's open. Gaps are the result of a temporary supply/demand imbalance, with prices dropping or rising sharply until balance is restored. This imbalance can be caused by many things, such as an after-hours earnings report that is significantly higher or lower than expected. Investors place orders for the next day based on the news, resulting in a gap between one day's close and the next day's open.
In this installment of Technically Speaking, we discuss four types of gaps—common, breakaway, runaway and exhaustion.
Common gaps are just that, common, and are usually non-events. Common gaps are also sometimes referred to as trading gaps or area gaps and tend to "get filled" fairly quickly. "Getting filled" means that the price action following the gap usually retraces at least back to the price prior to the gap. Figure 1 illustrates a common gap that is eventually filled or closed for Bed Bath & Beyond (BBBY). We can see that after the gap, prices come back down to the level at the beginning of the gap, thereby closing or filling the gap.
Common gaps usually appear in a trading range, where there isn't any real buying or selling interest in the stock.
Whereas the common gap produces few trading opportunities, the breakaway gap is, arguably, the most significant gap. As the name implies, breakaway gaps occur when prices are breaking out of a pattern, the implication of which is important.
Figure 2 shows that Hewlett-Packard Company (HPQ) had traded in the low-to-mid-40s for close to three months in early 2011, with support around $40 and resistance at $44.
In mid-May, however, the supply/demand balance changed and the stock gapped downward on May 17, 2011, losing over 7% on that day. On the gap breakout, volume, which has been averaging around 16.3 million shares, spiked to 100.4 million shares that day, its highest level since the previous August. Such heavy volume to the downside on the breakaway gap was a clear bearish signal for HPQ shares.
While a gap is defined by the space in prices, volume plays a pivotal role as well. First, higher volume associated with a gap confirms the significance of the gap. Second, volume plays a role in defining future support and resistance levels following the gap breakout.
On May 17, 2011, HPQ shares opened at $37.57 after closing the previous day at $39.80. The shares fell to a low for the day of $36.04 before closing at $36.91. The huge volume associated with that price level will define where subsequent resistance should be expected to develop.
As would be expected, HPQ tested the mid-37 level a few times over the next several weeks, but was never able to advance any higher. Volume at this level on the breakaway gap marked that approximate price level as resistance.
Runaway gaps, also called measuring gaps, are generally caused by increased interest in a stock. Runaway gaps during an uptrend usually represent traders or investors who missed out on the initial upward move. They had been waiting for a pause in the upward move or even a price retracement, but eventually gave up. This increased buying interest forces the price to gap upward above the previous day's close. Figure 3 shows a runaway gap for Bed Bath & Beyond (BBBY) in early April 2011. BBBY shares had risen roughly 10% in less than a month, and then on April 6, 2011, the company issued forward earnings guidance that was in line with analyst expectations. This guidance apparently reassured investors, as volume shot up to 12.1 million shares after averaging 2.8 million shares a day, and BBBY shares gained 10.4%.
Lastly, exhaustion gaps occur near the end of an up- or downtrend. Often they are the initial signal that the trend is coming to an end. Like other gaps, exhaustion gaps are accompanied by high volume and a large price difference between the previous day's close and the next day's opening price. It is easy to mistake a runaway gap for an exhaustion gap until the trend reverses itself.
Figure 4 shows an exhaustion gap that developed for MSC Industrial Direct Company (MSM) in early April 2011. In less than two weeks MSM shares had risen almost 11%; then on April 6, 2011, the company issued third-quarter 2011 guidance that exceeded analyst expectations. That day, MSM shares gained 6.4% on 1.9 million shares traded. The average daily volume at the time had been 280,000 shares.
However, as is the case with most exhaustion gaps, this gap was filled in quickly, within four days to be exact, as profit-taking led to a drying up of the demand that was driving the price higher.
Gaps can provide useful insight into the underlying trend in prices. In order to fully understand gaps and correctly read the signals they are providing, it is important to understand the behavior of the market as well as that of the underlying stock.
By familiarizing yourself with the price behavior of a given stock - especially with regard to the way prices behave when a gap occurs - you have a useful trading tool at your disposal.
A gap is defined as a price level on a chart where no trading occurred. These can occur in all time frames but, for swing trading, we are mostly concerned with the daily chart.
A gap on a daily chart happens when the stock closes at one price but opens the following day at a different price. Why would this happen? This happens because buy or sell orders are placed before the open that cause the price to open higher or lower than the previous day's close.
Let's look at a chart:
You can see on the chart above that the stock closed at one price and then the next day the stock "gapped up" creating a price void on the chart (yellow area).
Sometimes you will hear traders say that a stock is "filling a gap" or they might say that a stock has "a gap to fill". In Japanese Candlestick Charting gaps are referred to as "windows". When we say that a stock is "filling a gap", the Japanese would say that the stock is "closing the window".
They are talking about a stock that has traded at the price level of a previous gap. Here is a chart example:
In this example, you can see that the stock gapped down (yellow area). A few days later it rallied back up and filled in the price level at which there were previously no trades. This is known as filling the gap.
Sometimes you will hear traders saying that "gaps always get filled". This just simply isn't true. Some gaps never get filled, and sometimes it can take years to fill a gap. So I really don't even think it is worth debating because it offer no edge one way or another.
Traders have labeled gaps depending on where it shows up on a chart. It isn't really necessary to memorize all of these patterns but here is the breakdown so that you can impress your trading friends.
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When you are looking at gaps on a stock chart, the most important thing that you want to know is this:
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Here is an example of a gap caused by amateur traders:
See how this stock gapped up (yellow area) after a wave of buying occurred? These amateur traders got emotionally involved in the stock. They piled in after an already extended move to the upside.
These traders eventually lost money as the stock sold off over the next few weeks. Notice how the stock eventually did go back up - but only after a wave of selling occurred (and professional buying too).
Here is another chart:
See how this stock gapped down (yellow area) after a wave of selling occurred? These amateur traders got emotionally involved in the stock. They sold after an already extended move to the downside.
So...
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Support and resistance identify areas of supply and demand. Supply is an area on a chart where sellers are likely going to overwhelm buyers causing the stock to go down. On a chart, we call this resistance. Demand is an area on a chart where buyers are likely going to overwhelm sellers causing the stock to go up. On a chart, we call this support.
Stocks run into resistance (supply) because those traders that bought too late and saw the price go down now want to get out at break even so they sell. Stocks find support (demand) because those traders that missed the move up now have a second chance to get in so they buy.
Here is an example:
This stock broke through resistance. When it pulled back, it found support at the prior high. This chart shows how resistance, once broken, can become support:
Look again at the those areas that I highlighted in yellow. What are these traders doing buying stocks that are running up into an area of supply (resistance)? Why are they selling their stocks when it is falling down to an area of demand (support)?
They do that because they are amateur traders. They often buy after significant buying has already taken place into areas of resistance, and often sell after significant selling has already taken place into areas of support. On the next chart, the highlighted area in green is where professionals would buy the stock:
It works just the opposite for shorting stocks. Professional traders will short stocks after they rally to a prior support area. Like this:
The highlighted area in red is where professionals would sell the stock.
There are other forms of support and resistance that are not so common. For example, look for stocks that pull back and find support halfway into a prior wide range candle:
Or, look for stocks to pull back and find support halfway into a gap:
This line is where professionals will likely come into the stock. Amateurs do just the opposite of this.
You want sell stocks at that level? Don't follow the amateur traders!
Morning gaps drive traders crazy, because they hurl positions and assumptions into unknown territory. These shocking events also force an immediate re-evaluation of the charting landscape to deal with the altered reward-risk equation. But the extra work pays off, because the gaps may predict big changes in subsequent price action.
Gaps reveal shifts in crowd sentiment through single price bars. They can print anywhere within a pattern or trend, but they tend to occur in several common scenarios. Each type of gap generates unique characteristics related to persistence, response during retracements and impact on price movement.
Gaps cut through all time frames and trends, but they represent different phenomena in each one. For example, a breakout move in one time frame may print an exhaustion event in another.
A gap's importance is directly related to its location, range and volume. For this reason, a high-volume gap late in a trend often signals the end of the move:
A gap can print in the direction of the major trend, or against it. When it moves against current momentum, it triggers the only chart phenomenon that can signal trend change without a topping or bottoming pattern. A narrow-range or wide-range bar can stand at the end of the gap event. Long bars predict reliable follow-through in the direction of the gap. Short bars suggest sideways action, or a pullback into the violated space.
Take the time to distinguish between gaps in the direction of the trend and those moving against it. Countertrend gaps represent important shock events when they occur near big highs or lows. For example, a price break in the wrong direction after a strong rally can produce considerable fear and lead to much lower prices.
Gaps through major support and resistance levels signal breakouts and breakdowns. Emotions can build so strongly at these levels that the gap exceeds common sense and sets off a violent reversal. Strong greed or fear can trigger multiple gaps as a growing trend builds momentum. Gaps that print within sideways patterns show less persistence and can fill with little warning or volume.
Gap creation aligns with Elliott Wave Theory. The breakaway gap corresponds with the breakout that occurs during the dynamic first-wave impulse. Runaway emotions trigger the continuation gap at the center of the third-wave rally or selloff. The trend sequence ends with the fifth-wave exhaustion gap.
The continuation gap should mark the halfway point of a trend. Traders familiar with waves can use this projection to target potential reversal levels. Visualize the gap as soon as possible after the fourth wave begins. Then draw an extension from the edge of the first wave into the continuation gap. Then double that distance and wait for price to push into the target level. Enter a position in the opposite direction when price moves out of a reversal pattern in a smaller time dimension.
High-percentage gaps can exhaust further movement in that direction for an extended period of time. The reason is simple: The big move forces all uncommitted players off the sidelines, while winners take profits and losers take losses. This provokes an overextended condition that forces a reversal back toward the prior bar.
Opening gaps fascinate traders but require solid execution skills. Cash seeks opportunity at the start of the day while insiders paint the tape to encourage execution. This encourages a supply-demand imbalance, with ill-advised orders well above or below the market, depending on the gap direction. The resulting friction can set the stage for a reversal just minutes into the new session.
No easy formula shows traders how far a gap can travel and still remain healthy. But we need to apply common sense when observing premarket action above or below the last closing price. The most important question for traders to consider: Does the news and market environment justify the price you're seeing?
The level of crowd participation limits or fuels the strength and durability of the gap event. Certain gaps verify only when strong volume accompanies them. For example, a breakaway gap without heavy volume suggests it will eventually yield to a failed breakout.
The relationship between gaps and the crowd relies on complex interactions. For example, a high-volume gap may end movement in that direction because it uses up the last available supply for that trend. But another gap with less volume leaves just enough on the table to ensure sustained movement in that direction.
Old traders' wisdom tells us that gaps get filled. Usually, brokerage houses creates them, opening synthetic positions against their clients. This classic expression does a good job describing the mechanics of retracement found in most trends, but, however, some gaps never fill - and some gaps will indicate the end of the movement. This suggests using common sense with these specialized patterns. Learn the unique characteristics of each gap type and then apply the strategy that aligns best with its behavior.