Anyone who has spent time looking at charts will be familiar with the sight of a price gap. But not all are attuned to the different types of gaps that exist or what they mean to the technical trader.
Below, we identify four common types of price gaps, along with an explanation of the significance of each.
Defining the Term
Gap is a term that describes the space that opens between two consecutive trading periods because prices from one period to the next did not overlap. In practice, it looks like this:
Gaps normally occur on daily charts, after a post-market earnings surprise or some other news sends shares much higher (or lower) at the beginning of the next day’s trading.
While one gap may resemble the next, they’re actually quite distinct from one another, and trading them requires some knowledge of their typology.
1. Common Gaps
Most gaps are common gaps. They’re temporary skips higher or lower that end up being “filled” as the stock retraces to cover the price range that was missed. Here’s an example of a common gap:
As the chart shows, a short-term trader might have profited nicely by betting on a pullback to the bottom of the gap that opened in the lower left corner of the chart.
Common gaps are often formed during periods of low trading volume or a prolonged sideways move in a stock.
2. Exhaustion Gaps
Exhaustion gaps are found at market tops and, like common gaps, they also reverse course in short order. As their name suggests, upside exhaustion gaps represent the last massive rise in a security before demand dries up and sellers take control.
But they can also be found at market bottoms, as traders close out their positions in one final spasm of selling that moves the security significantly lower and supply is exhausted. At that point, buyers will step in to launch a new bull move.
Exhaustion gaps are generally identified by outsized volume figures that quickly fade.
Here’s an example of an exhaustion gap:
The chart illustrates a textbook upside exhaustion gap, after which the stock reversed and went on to post stunning losses. In this case, the volume spike appeared a day after the gap higher, when the stock struck higher highs before turning down.
3. Breakaway and Runaway Gaps
Breakaway gaps are similar to runaway gaps save for one detail. The former come on the heels of a range-bound market, while the latter occur while a security is already trending. Both are generally accompanied by greater-than-average volume, and – this is crucial – both tend to continue in the direction of the gap for some time.
For traders who are intending to play a retracement off a breakaway or runaway gap, be forewarned: it may take a considerable amount of time – even months – before a “fill” of the gap occurs.
Here’s an example of a breakaway gap:
Note the three-month period of consolidation directly before the breakout. The gap signals a strong subsequent bullish move is at hand.
This is a runaway gap:
Here, volumes picked up dramatically as the stock sunk.
Know your gaps! You’ll trade more effectively.
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