Technical Analysis: What are gaps?

Published: 28 July 2008 By Sunil Tinani Leave a Comment

If you have ever watched business TV channels or browsed through market-related websites, you’d have surely come across the terms “gap up opening”, “gap down opening”, and other such phrases that contain the word “gap” in them. Well, in simple terms a gap refers to the abrupt price leap or plunge that occurs in the opening price of a stock compared to previous trading day’s closing price, with no trading taking place in the gap price region. Mathematically, a gap is reflected as a discontinuity, or break, in the curve on the price chart.

A gap can be up or down depending upon whether the price has jumped up or plummeted. A gap up is said to be full if the day’s low remains consistently higher than previous day’s high. Similarly, a gap down is said to be full if the day’s high remains consistently lower than previous day’s low. In these two cases there is no overlap between the trading curves of the two consecutive days.

Gaps can be triggered by different events happening during the time interval between two consecutive trading days – for example, company announcements, adverse or favorable economic news, government announcements, or some international event like a surge or dip in the price of crude oil.

Here are some examples that will help you understand gaps better:

  1. The volatility in the markets nowadays makes traders and short-term investors square up their positions every Friday or on the day before a public holiday, because they are afraid that if any adverse economic announcements are made on weekends/holidays, the stocks will open weak on the next trading day. But if any favorable announcement or news comes over the weekend/holidays, then the stock will jump up on the next working day. In the absence of any news or announcements, the stock may jump a bit at the opening but then the gap will get bridged.
  2. If a stock goes ex-dividend on a day (which means that the stock shares purchased hereafter do not entitle the buyer to receive the most recently declared dividend, the right to which remains with the seller), then it will open with a gap down (reflecting the dividend adjustment) the next day.
  3. If a company announces positive or negative results after the close of a trading day, then its stock will open with a gap up or gap down, respectively, the next trading day.

So, it follows that if there’s a gap up or down, there is some fundamental factor or a news announcement that is influencing the price of the stock. Gaps, even though influenced by news and fundamentals, are connected to technical analysis. To understand the relation, you must first understand the different types of gaps – common, breakaway, runaway and exhaustion.

Common gaps

These gaps are of no importance to a technical analyst, as they do not indicate profitable trades on the chart. They are usually caused by a stock going ex-dividend or by a freak opening, and they get filled up pretty quickly; so, don’t bother much about these.

Breakaway gaps

Breakaway gaps are exciting and significant gaps that signal the beginning of a new trend (upward/downward) in the price action. When a share has been steadily moving in a narrow price range for quite some time and then breaks out of this range to jump/dive to a new range, probably due to a sudden optimism or pessimism, a breakaway gap is said to occur.

Breakaway gap example

Breakaway gaps give strong trading signals, especially if accompanied by significantly high volumes, which indicate that something is up and the stock’s trend has changed. But if the volumes are thin then the gap may get filled up sooner or later and lose its significance. However, if a breakaway gap is confirmed then the new trend is considered as established.

Runaway gap or measuring gap

When the investor/trader interest in a stock heats up, then they chase the stock and want to buy it no matter how fast it climbs up. So, no matter what support or resistance levels a stock might have, if it opens with a significant price gap that reinforces the ongoing trend (up/down) then a runaway gap occurs, as shown in Figure 2. The rider here is that the gap must be accompanied by high volumes – more than the average volumes traded. If the volumes are thin – then the gap analysis won’t hold good.

Runaway gap example

Exhaustion gap

When a stock moves up for a considerable length of time, many traders may want to square up their positions. For example, a trader/investor who has bought it at a low rate may feel like booking profits. When many such people begin selling, they spark a chain reaction, giving rise to an exhaustion gap (Figure 3). An exhaustion gap occurs close to the end of a trading session, after the spurt in a stock’s price “gets exhausted” and begins to tail off. It usually reflects that the demand for the stock has started to decline. It is considered as a temporary gap that will get filled up once the demand picks up again. Similarly, an exhaustion gap can occur in the downward trend too. In general, exhaustion gaps indicate a temporary end of an upward/downward trend.

Exhaustion gap example

Conditions governing gaps

For gap analysis to be effective, all gaps must be accompanied by good volumes, which are higher than the average volumes. So, it naturally follows that gap analysis takes into both prices as well as volumes.

Also, if you spot a profitable trade using gap analysis, do keep the type of market (bull or bear) at the back of your head. For example, if the market is bearish and you spot a runaway gap upwards, then by all means enter into the trade, but do not hold the stock for a long time – book your profits quickly. However, if the market is bullish, then you can hold on to your trade, and so on.

You can try gap analysis and spot profitable trades now, without waiting to become an amateur technical analyst.

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