Indicators: i-GAP
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.
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 (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 GapsBreakaway 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 GapsExhaustion 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.
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i-GAP:
Author: Nikolay Kositsin