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Gaps: Definition, Importance, Types, Causes and Examples          

Gaps: Definition, Importance, Types, Causes, How to Trade and Examples

Gaps: Definition, Importance, Types, Causes, How to Trade and Examples

A gap is a capital market term that is used to describe discontinuation in a price chart. A gap is formed when the closing price of the previous day and the opening price of the next day have different price levels. A gap is caused because of the change in market fundamentals when the market closes.

A gap is a result of low liquidity in the market and a high trading volume of the stock. Gaps are common occurrences but all of them do not have equal significance. The experience of the trader is an important factor when it comes to considering or ignoring the correct gap.

Any news related to a specific stock after the trading session forms a gap. Market news on earnings release and the company affects investors sentiment either positively or negatively after the stock closes. This leads to gaps in the stock prices when the stock opens the next day. The stock of a company gaps up the next day if the company’s earnings are higher than expected.

Gaps are important for technical analysis because they signal shifts in the supply and demand equilibrium. Major gaps indicate a substantial imbalance between buyers and sellers, causing a swift repricing.

There are four common types of gaps. Breakaway gaps form at the start of a new trend as prices break out of a trading range. They signal a transition from consolidation to directional movement. Runaway gaps occur during an established uptrend or downtrend as enthusiasm builds. This confirms the strength of the trend. Exhaustion gaps, on the other hand, represent unsustainable volatility and the potential end of a trend. Large volume accompanies exhaustion gaps. Common gaps appear within a trend and reflect a slight imbalance between buyers and sellers. They are less significant than other types of gaps.

The factors that cause gaps include the release of earnings reports, news events, economic data releases, and changes in analyst ratings. Technical factors such as breakouts from resistance or support levels, also lead to gaps.

Traders trade gaps through buying or shorting the stock on confirmation of the gap direction. Stop-losses are placed on the other side of the gap since prices must not retrace. Gap trading strategies aim to benefit from the accelerated movement gaps represent.

For example, a breakaway gap signals new upward momentum. Traders buy the stock after the confirmation of the gap direction for continuation. Precise gap trading relies on carefully timing entries and managing risk.

What does Gap in Technical Analysis mean?

A Gap in Technical Analysis is the price level that is noticed between two consecutive time periods where there is no trading activity. A gap in technical analysis signals a difference between the opening price of one time period and the closing price of the previous time period. Price movement and volume are two important aspects of a gap in technical analysis.

What does Gap in Technical Analysis mean?
Gaps: Definition, Importance, Types, Causes, How to Trade and Examples 27

There are two ways in which gap appears in technical analysis – upside gap and downside gap. The upside gap occurs when the price opens above the previous trading period’s highest price. The downside gap occurs when the price opens below the previous trading period’s lowest price.

Gaps in technical analysis are an indication of an impending change in trend. Gaps in technical analysis show that a price has jumped and they represent significant changes in current trends to assess what is happening with the stock and likewise, present a trading opportunity. Technical analysis has traditionally been an extremely visual practice and hence, technical analysts easily notice gaps. Gaps are visually conspicuous on a price chart.

What is the other term for Gap?

The other term for gap is window. They are known as windows in Japanese candlestick charting and as gaps in the west. 

What does an Up Gaps indicate?

An Up gap indicates that the lowest price for the day is higher than the highest price of the preceding day. This means that today’s low is higher than yesterday’s high.  An up gap is usually represented by a bullish sentiment.

What does a Down Gap mean?

A Down gap or a downward gap means that the highest price for one day is lower than the lowest price of the preceding day. This means that today’s high is lower than yesterday’s low. A down gap is usually represented by a bearish sentiment.

What is the significance of gaps in technical analysis?

The gaps appear in the market as either gap ups or gap downs. Both these circumstances help to indicate the market trend. Gap up refers to a situation where the opening price of the current trading day is greater than the closing of the previous day. The gap up in the market indicates an uptrend where the prices of the security is pushed to greater highs. The trader utilizes this and enter into long positions. The same applies to gap downs. Gap down refers to citations where the opening price of the current day is lower than the closing of the previous day. The traders bet on short positions on these situation and bag profits.

The gap also helps gauge the magnitude of the trend. The greater the gap up or down, the greater is the strength of the up or down trend. The gap gives a picture of how much confidence the traders have in the security and the traders sentiment when the market opens. 

Gaps in technical analysis is an important aspect in the formation of chart patterns. The chart patterns provide useful information about future price movements. These chart patterns help traders in making decisions and identify potential entry and exit points.

The gaps in technical analysis are used to dictate what is done next in the market by the traders.The trader integrates the gaps into technical analysis by indulging more and more variable factors and tools.

What are the different types of gaps?

There are 5 different types of gaps that appear at different stages of the trend. The important factor here is to be able to distinguish among them to provide useful and profitable market insights. The 5 types of gaps that occur in a price line are exhaustion gap, breakaway gap, runaway gap, common gap and island gap.

1. Exhaustion Gap

An exhaustion gap usually occurs at the end of a trend or at an important support and resistance level. The price makes one last attempt to move higher in the case of an uptrend. The trend is exhausted and the higher price is sustained.

Exhaustion Gap
Gaps: Definition, Importance, Types, Causes, How to Trade and Examples 28

During an uptrend, exhaustion gap is not followed by new highs and in case of a downtrend, exhaustion gap is not followed by new lows. Exhaustion gap is only confirmed when prices reverse and close. Exhaustion gap is often associated with a rise in price along with an increase in volume. It is also mistaken for runaway gaps if one does not notice the exceptionally high volume. 

Traders usually compare both price and quantity to distinguish between the two. They are identified by high volume and a large price difference between the previous day’s close and the new opening price. It is called an exhaustion gap if both price and volume increases. Exhaustion gaps usually get filled and the best way to trade an exhaustion gap is not to speculate but use the information to time exits and entries around the pattern.

Exhaustion gaps are considered as an almost state of panic if the gap appears during a long down move. At this point, selling all positions to liquidate holdings in the market is not uncommon. Exhaustion gaps are quickly filled as prices reverse their trend. Buyers do not get enough of that stock if they occur during a bull move and bullish sentiment overcomes the trades. The prices gap up with huge volume and there is great profit taking. The demand for the stock totally moves down. This leads to a price drop and a significant change in the trend occurs. Exhaustion gaps are probably the easiest to trade and profit from. These gaps are also associated with rapid, extensive advances or declines.

2. Breakaway Gap

A breakaway gap is one that occurs at the beginning of a trend. A breakaway gap indicates that the price of the stock gaps over a support or resistance level. It is like a breakout pattern but here the actual breakout happens in the form of a gap. The breakaway gap usually does not get filled initially. This kind of gap signals strong momentum and the price keeps on trending after a breakaway gap. The strength of the prevailing trend depends on the size of the breakaway gap and the strength of the candle after the gap. The prevailing trend is stronger if the breakaway gap is larger and the candle after the gap is stronger.

Breakaway Gap
Gaps: Definition, Importance, Types, Causes, How to Trade and Examples 29

Breakaway gaps form when the price tries to break away from the congestion area. Congestion area refers to the price range in the market where the trading is happening for a while. The highest point in the congestion is usually called the resistance when approached from below. The lowest point in the congestion is called the support level when approached from above.  A breakaway gap occurs when the market breaks out of the resistance or support barrier. It needs market enthusiasm to cause a switch in trend. That is, either too many buyers for upward movement or sellers for the downtrend swing.

Volume of the stock must pick up after the gap when a breakaway gap occurs, confirming the direction change. A new support level is created where the market breaks out. The new resistance level is adjusted where the trend breaks downward. The appearance of breakaway gaps usually take a longer time to fill up. A good breakaway gap happens when it is associated with the classical price chart.

Breakaway gaps are considered the most profitable gaps for trading purposes. These gaps occur on almost every decisive breakout from horizontal congestion. Once the breakaway gap is observed, the market moves in the direction in which the gap has occurred. People who hold positions on the other side of breakout are forced to close their existing positions which further increase the momentum in the price.

3. Runaway Gap

A gap that occurs along a trend line is called a runaway gap or a measuring gap. A runaway gap appears in a strong trend that has few minor corrections. Runaway gaps are often referred to as measuring gaps because of their tendency to occur at about the middle of a price run.

Runaway Gap
Gaps: Definition, Importance, Types, Causes, How to Trade and Examples 30

This type of gap reveals a situation where the market is moving effortlessly on moderate volumes.  These gaps occur in the middle of a powerful trend, i.e., a trend which is making higher highs or lower lows without filling the gap. It is almost similar to breakaway gaps but just differs in location.

Runaway gaps are best described as gaps caused by increased interest in the stock. Runaway gaps to the upside typically represent traders who did not get in during the initial move of the up trend and waited for a retracement in price but decided it was not going to happen.This leads to an increased buying interest which happens all of a sudden and the price gaps above the previous day’s close. This type of runaway gap represents a near-panic state in traders. A good uptrend also have runaway gaps caused by significant news events that cause new interest in the stock. Runaway gaps also happen in downtrends. This usually represents increased liquidation of that stock by traders and buyers who are standing on the side lines. This becomes a very serious situation as the price has to continue to drop and gap down to find buyers.

An important factor here is the significant increase in volume during and after the runaway gap. The term measuring gap is also used for runaway gaps. This is an interpretation that is hard to find but it is a way to help to make a decision on how long a trend will last. The theory is that the measuring gap occurs in the middle or halfway through the move. The futures market sometimes has runaway gaps caused by trading limits imposed by the exchanges.  

4. Common Gap

Common gaps are the most commonly observed gaps in the market. Common gaps are also called trading gaps or area gaps. Common gaps are usually caused by regular market forces and don’t require a special event. They frequently occur in the stock market when a new trading day starts. They also occur in the middle of the trading day in times of strong buying or selling pressure. These gaps are observed when the market is in a range.

Common Gap
Gaps: Definition, Importance, Types, Causes, How to Trade and Examples 31

Common gaps get filled in a short period of time.Filling a gap means that the price reaches to the point where it was on the previous day of the gap. Many times common gaps are accompanied by low volumes. Gap up or Gap down with low volume shows the weakness in trend. This leads to reversing the price and filling the gap.

These gaps normally occur in calm and quiet markets rather than trendless markets. There are no new highs after an upside gap or new lows after a downside gap. There is a slight increase in volume on the day of a common gap which returns to average volume in the rest of the days. The absence of new highs and new lows show a lack of bullish and bearish sentiment. These gaps have a tendency to occur in a price congestion pattern.

5. Island Gap

Island gaps are two gaps which with the combination of price actions leads to the formation of island reversal patterns. They form in between the two gaps. Island gaps indicate that the island reversal marks a sudden and sharp shift in direction. Island reversals are potent patterns that draw our attention even though they are relatively uncommon.

Island Gap
Gaps: Definition, Importance, Types, Causes, How to Trade and Examples 32

The alignment of the gaps holds the key. A gap down and then a gap up leads to the formation of a bullish island reversal. A bearish island reversal forms with a gap up and then a gap down. These gaps overlap to create an island of price action and hence the term island gap. The island is above the island gaps on a bullish island reversal and below the island gaps on a bearish island reversal.

An Island gap is characterized by a lengthy trend leading into the pattern and an initial price gap. There is a cluster of price periods that tend to trade within a definable range. A pattern of increased volume near the gaps and during the island compared to preceding trend and a final gap establishes the island of prices isolated from the preceding trend.

These are the different types of gaps. Traders build a trading strategy based on the type of price gaps formed. They are easy to spot but determining gaps and interpreting gaps requires knowledge and practice.

What causes gaps?

Gaps are extremely common in the financial market. They provide various insights to traders and it is important to understand the causes to use them effectively in trading strategies. The following are mainly the three causes for the formation of gaps.

  1. Low liquidity: A gap usually occurs when there is low liquidity in the market. There are not enough buyers or sellers to trade that stock in this situation. The market does not have sufficient buyers and sellers to stop unexpected slumps and spikes in stock price.
  2. High volume: A gap occurs when there is a high volume in the stock. Gaps are usually seen after a trading day ends and the market opens the following day again in the stock market.
  3. Earnings: Important events like earnings and company related news impact the market sentiment after the stock closes. This leads to gaps in the stock prices when the stock opens the next day and the trading resumes. Most traders are likely to place an order the next day if the earnings are higher than the expected earnings. This results in the price opening higher than the previous close.

Knowing the causes of gaps makes understanding them and their importance easier. As a result, one uses it to the fullest.

How often does Gap appear on stocks?

A Gap appears on stock daily, weekly, monthly and intraday depending on the type of gap. The ups and downs are reflected on the daily, weekly or monthly charts,and are considered significant when accompanied with higher than average volume.

Gaps are more fequent on daily charts where every single day is considered as an opportunity to create an opening gap. Gaps on weekly or monthly charts are fairly rare. These gaps 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. Prices often gap up or down as market opens but the gap does not last until the market closes.

What happens when the Gap is filled?

A gap being filled or gap fill trading refers to the price returning to the original level before the gap happened. Once the gap is filled it usually means the price action in the following days or weeks retraces to the last day before a gap. There are price corrections required due to an overly optimistic or pessimistic initial spike. The support and resistance level isn’t left behind when a price moves up or down sharply and the price reversals seen with exhaustion gaps are likely to be filled as this type of gap signals the end of a price trend.

How does Gap affect stock price?

To understand how gaps affects the stock, it is important to understand the instances that arise when gaps occur. Whether it is a gap up or a gap down, it is always recorded with reference to two consecutive day’s price levels. A full gap up occurs when the next day’s opening price is higher than the high price of the previous day. A full gap-down occurs when the opening price of the stock is lower than the previous day’s low price. A partial gap-up occurs when the opening price is above the previous day’s close but not above the previous day’s high price. On the gap-down front, it occurs when today’s price is below the closing price of yesterday but not below the low of yesterday. These four instances show how gap affects the stock price.

How are Gaps in a Chart made?

A gap in a chart is made when the closing price of the previous days and the opening price of the next day have different price levels. This is formed mainly due to any news in that specific stock, after the trading session. The stock of a company gaps up the next day if the company earning is higher than expected

Can Gaps be used to predict Market trends?

Yes, gaps are used to predict market trends. Continuation gaps signal a strong trend and this is used by traders to enter in the direction of the trend after a continuation gap occurs. Exhaustion gaps signal trend reversals and this is used by traders to enter the opposite trend after they spot this gap. Up gaps usually indicate uptrend and down gaps indicate downtrend.

How to trade using a Gap Chart Pattern?

There are significant strategies that help traders trade using a gap chart pattern. 

How to trade using a Gap Chart Pattern?
Gaps: Definition, Importance, Types, Causes, How to Trade and Examples 33

Firstly, consider trading in the direction of the gap if the gap is a breakaway gap. For example, take a long position when a breakaway up gap signifies an uptrend in the beginning. On the other hand, go for a short position when a downtrend is assumed in the beginning due to a breakaway down gap. 

Secondly, trade in the direction of the gap if the stock is trending and a measuring gap occurs. 

Thirdly, trade in the direction of the gap as a continuation strategy when the price continues in the direction of the gap.

How to identify Gaps in Trading?

A gap in trading is identified by looking at a candlestick chart. A gap is the difference between the closing price of one candle and the opening price of the next candle. Listed below are the points to consider to learn to identify the gaps in a chart pattern.

How to identify Gaps in Trading?
Gaps: Definition, Importance, Types, Causes, How to Trade and Examples 34

First, it looks like an empty area in between the candles on a chart. Second, the candle opens much lower than the previous day’s close. Third, the green shaded area shows the gap in between the candles.

Fourth, the gap is that unfilled space between the end of one trading period and the opening of another one as shown above. 

A gap does not necessarily happen overnight when markets are closed. It also occurs on a shorter time frame during the day. The price tends to fill the gap whenever a gap occurs on a price chart. 

How can Gaps be incorporated into a Trading Strategy?

There are three ways in which traders incorporate gaps into a trading strategy. As gaps provide useful insights about market trends and trading opportunities, it is used by traders as a strategy to determine the strength and direction of the trend. Identifying what gaps signify helps trade better. The first way is to follow the trend. In case, the traders stumble upon news that triggers a bullish trend/ bearish trend in the market the next trading day, they use it to their advantage using the relevant trading strategy.

Gaps allow trader to predict the gap by analyzing the information they gather and placing after market orders. After market orders are placed after the market closes and the orders are executed the minute the market opens. Fading the gap is another way, involving greater risk than the other two strategies. Fading gap strategy refers to following the up trend or down trend that is created by the gap or gap down respectively and wait for the trend to peak ( if its an uptrend) or reach its trough ( if its a down trend) and then act accordingly. It is to note that this strategy is suitable for experienced traders who have a greater risk appetite.

The three methods that utilizes the gap involve risk and are made more efficient using more technical tools and indicators. Careful analysis and experience is required for proper implementation gap strategy in technical trading.

What indicator can be used in combination with Gaps?

Traders use indicators in combination with gaps for more effective trading. The tools include the Exponential Moving Average (EMA) and Relative Strength index (RSI) in combination with gaps. This is used to ascertain key price points and inform the trader’s decisions. The exponential moving average is a technical chart indicator that tracks the price of an investment (like a stock or commodity) over time. The relative strength index is a momentum indicator which is used in technical analysis.

Does a Gap pattern need to be confirmed with other technical indicators before trading?

Yes, a gap pattern must be confirmed with the other technical indicators before trading. Gaps do help in understanding market behavior and enable traders make informed trading decisions. However, relying on it alone is quite risky. Hence, it must be confirmed with technical indicators to avoid losses or breakouts.

What are examples of Gap used in Trading?

The example of gap used in trading is explained below.

What are examples of Gap used in Trading?

Suppose, stock XYZ closed  at $50 on 1/29/09 and reported earnings after the market closed that were much better than the expected earnings. In after hours trading, XYZ stock traded higher on the earnings and the next morning, it opened at at $57.36, which was 14.7% higher.

The chart shows the large gap on the chart and the increased volume from the earnings announcement.

Can Gaps be used to identify support and resistance levels?

Yes, gaps are used to identify support and resistance levels. The gap functions as resistance when the price gaps downward. The gap functions as a support to prices in the future when the prices gap upward.

Can Gaps be used as reliable trading signals in technical analysis?

Yes, gaps are used as reliable trading signals in technical analysis. A gap in technical analysis occurs depending upon the trading periods highest and lowest price. They are easily noticed and they are reliable as technical analysis is a visual practice.

Are all Gaps equally significant as trading signals?

No, gaps aren’t equally significant as trading signals. Experienced traders know which gaps to take note of and which to ignore.

Arjun
Arjun Remesh

Head of Content

Arjun is a seasoned stock market content expert with over 7 years of experience in stock market, technical & fundamental analysis. Since 2020, he has been a key contributor to Strike platform. Arjun is an active stock market investor with his in-depth stock market analysis knowledge. Arjun is also an certified stock market researcher from Indiacharts, mentored by Rohit Srivastava.

Shivam
Shivam Gaba

Reviewer of Content

Shivam is a stock market content expert with CFTe certification. He is been trading from last 8 years in indian stock market. He has a vast knowledge in technical analysis, financial market education, product management, risk assessment, derivatives trading & market Research. He won Zerodha 60-Day Challenge thrice in a row. He is being mentored by Rohit Srivastava, Indiacharts.

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