Gaps are one of the most easily recognisable technicalindicators. A gap is simply an empty spot formed on a price chartwhen prices do not overlap the previous bar’s price action. Thisis a useful concept to keep in mind because it helps to explainsome of their technical consequences. Sometimes market psychologychanges overnight or over a weekend and that change in psychologycan force prices to open and stay above or below the previousday’s range.
Gaps on daily and intra-day charts are most reliable. They canappear on longer-term charts such as weekly charts, but are rare.Gaps on monthly futures charts are very rare because they generallyare constructed to avoid gaps caused by contract changeover.
Figure 297: Price Gaps where the market opens at a significantlydifferent level to previous price action, causing empty spots inthe chart.
Bullish Gaps on daily bar charts are produced when the lowestprice at which a stock, commodity, or futures contract is traded onany one day is higher than the highest price at which it traded onthe preceding day.
Bearish Gaps appear when the highest price of one day that amarket is traded at is the lower than the lowest price of thepreceding day.
When the ranges of any two such days are plotted, they will notoverlap or touch the same horizontal level on the chart. There willbe a price Gap between them.
For a Bullish Gap to develop on a weekly chart, it is necessarythat the lowest price recorded at any time during the week behigher than the highest recorded price during the previous week.This can happen, but not as often as on daily or intra-dayGaps.
(Bearish Gaps occur when the highest price of the week does notreach the lowest price achieved during the previous week.)
Monthly chart Gaps are rare in actively traded markets. Theiroccurrence is confined almost entirely to those few instances wherea panic decline or panic buying spree commences just before the endof a month and continues through the first part of the followingmonth.
In general technical analysis, Gaps may serve one of threepurposes:
They are used to spot the beginning of a move;
Gaps are used to measure a move;
And Gaps are used to signal the end of a move.
And there are four types of Gaps:
Common or temporary gaps;
Breakaway gaps;
Measuring or runaway gaps;
And Exhaustion gaps.
Common or Temporary Gaps
The most frequently occurring Gap is the Common Gap…(Obviously&033). When this Gap occurs because of a slight change onpsychology, traders expect it to soon be filled. Once a gap isfilled, it no longer has significance in terms of analysis orforecasting.
A Common Gap tends to occur frequently in a trading range orprice congestion area. All of the congestion formations which Ihave illustrated (Wave 2’s, Wave 4’s, Flags, Triangles, etc.)regularly contain Common Gaps. This is because activity in thesepatterns tends to be concentrated near to the top and bottom edgesof the pattern, i.e. the formation’s trendlines.
While a market is in between a congestion’s trendlines, it isin much of a "no-man’s land". Therefore, it is easy to see whyGaps develop frequently within such areas.
Figure 298: Common Gaps occur in price congestions or tradingranges.
Because this is the most common type of gap, it is the one Ihave found to be quite valid. It obeys the rule that "gaps areoften filled". When I see a gap in a congestion area, I will oftenwait for prices to come back and "fill the gap" rather than enter atrade.
The forecasting significance of Common Gaps is practically nil.They have some use simply because they help to recognise an areapattern. That is, they imply that the congestion formation is inthe process of construction.
In congestion areas, there may be as many as 5 or 10 Gaps.
If the market fails to fill this gap after a couple of weeks,this confirms a Breakaway Gap (see below) and one can then thinkabout riding the trend.
Breakaway Gaps
A Breakaway Gap appears in connection with a price congestion area,but it develops at the completion of the formation in the movewhich breaks prices away. Any breakout through a horizontal patternboundary, such as the top of an ascending Triangle, is likely to beattended by a Gap.
In fact, it is safe to say that most of them are.
Figure 299: Breakaway Gap after a congestion area.
Continuation, Runaway and Measuring Gap
A Continuation or Runaway Gap is less frequent in its appearance.But they can be significant in that they can provide some clues toforecast a probable end of the trending move. For this reasonContinuation or Runaway Gaps are sometimes called MeasuringGaps.
As opposed to the Common Gap or the Breakaway Gap, which form inor around an area of congestion, a Runaway Gap is not associatedwith area patterns. It occurs in the course of rapid, near-verticaladvance or decline.
Supposedly, the Runaway Gap occurs around the halfway point of aprice move, between the beginning of the trend move (e.g. the startof Wave 1) and the end of the move (e.g. the end of Wave 5).Therefore, measuring the height of price action between the startof a trend and the Runaway Gap two can predict the end of thetrend.
However, although this idea can HELP to forecast the length of atrend, I have found that this technique does not work asconsistently as some of my other forecasting techniques. But if theGap-measuring method predicts a similar end as my other techniques,it adds weight to the likelihood of a top/bottom at this price.
Figure 300: A Runaway Gap can be used to help forecast an objectivefor the end of a trend. Measure from the start of the trend to theRunaway Gap and project this from the Runaway Gap (i.e. the RunawayGap is at the halfway point of the move). In this example, themarket fell lower than the Gap-measuring technique forecast. Notehow the fall from around 39 contained 3 waves all of around thesame length – a more reliable method.
Exhaustion Gap
The Breakaway Gap signals the start of a move; the Runaway Gapmarks its rapid continuation (supposedly around the half-way pointof the move); an Exhaustion gap shows signs of the marketsputtering to an end.
Exhaustion Gaps are associated with rapid advances or declinesat the end of price trends.
Though prices may go higher after an exhaustion gap at the top,the rally will not last long before the market dies.
Figure 301: Exhaustion Gaps (red rectangles) show a final strongburst to a new high or low. If the gap is filled, it is obviouslyNOT a Runaway Gap and is likely to be an Exhaustion Gap.
The Island Reversal
The Island Reversal pattern is uncommon and in itself is not ofgreat significance in the sense of denoting a long term top orbottom. But it does, as a rule, send prices back for a completeretracement of the minor move that preceded it.
An island usually occurs at the end of an Exhaustion Gap andcould be viewed as forming its own narrow trading range at the topof the reversal. The island can last for only a single day, inwhich event, it usually takes the shape of one of the reversal barshapes given above (Test, Key Reversal, Shooting Star).
Or the Island may be made up of several days or weeks of minorfluctuations of a congestion area. The Gaps at either end of theIsland occur at approximately the same level so that the whole areastands out as an Island on the chart, isolated by the Gaps from therest of price action.
The reasons why Islands develop – in other words, why Gaps dorepeat at the same price level – are usually because prices canmove and repeat through a wide range where little or no orders havebeen placed in the past; where previous owners have no vestedinterest and where there is no support/resistance from previousprice action.
Figure 302: Some Island Reversals which occur as part of anExhaustion Gap. Once the gaps have been filled, it is then provedthat the gap was not a Runaway Gap. Therefore, it is likely thatthe trend has come to an end and a reversal has taken place.
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How to trade gaps on a stock chart?
Are all gaps created equally? Nope. There are really only twosignificant factors to consider when trading gaps.
You have to be able to identify if the gap is caused byprofessional traders or amateur traders. There is a big differencebetween the two&033
Wait a minute...let's back up a second...
What is a gap? A gap is defined as a price level on a chartwhere no trading occurred. These can occur in all time frames but,for swing trading, we are mostly concerned with the dailychart.
A gap on a daily chart happens when the stock closes at oneprice but opens the following day at a different price. Why wouldthis happen? This happens because buy or sell orders are placedbefore the open that cause the price to open higher or lower thanthe previous day's close.
Here is an example:
Let's say that on Tuesday, Microsoft closes at $26.57. After theclose they come out with their earnings report. They report higherthan expect earnings that causes excitement among investors. Buyorders come flooding in. The next day Microsoft opens at $27.60.Since there were no trades between $26.57 and $27.60 this willcreate a gap on the chart.
Let's look at a chart:
You can see on the chart above that the stock closed at one priceand then the next day the stock "gapped up" creating a price voidon the chart (yellow circle).
Filling The Gap
In Japanese Candlestick Charting gaps are referred to as windows.When we say that a stock is "filling a gap", the Japanese would saythat the stock is "closing the window".
Sometimes you will hear traders say that a stock is "filling agap" or they might say that a stock has "a gap to fill".
Are you wondering what the heck they are talking about?
They are talking about a stock that has traded at the pricelevel of a previous gap. Here is a chart example:
In this example, you can see that the stock gapped down. A fewdays later it rallied back up and filled in the price level atwhich there were previously no trades. This is known as filling thegap.
Sometimes you will hear traders saying that "gaps always getfilled". 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'teven think it is worth debating because it offer no edge one way oranother&033
Types Of Gaps
Traders have labeled gaps depending on where it shows up on achart. It isn't really necessary to memorize all of these patternsbut here is the breakdown so that you can impress your tradingfriends.
Breakaway Gaps - This type usually occurs after a consolidationor some other price pattern. A stock will be trading sideways andthen all of sudden it will "gap away" from the price pattern.
Continuation Gaps - Sometimes called runaway gaps or measuringgaps, these occur during a strong advance in price.
Exhaustion Gaps - This type of gap occurs in the direction of theprevailing trend and represents the final surge of buying orselling interest before a major trend change.
Ok, now we are going to get into the really good stuff...
Professional vs. Amateur Gaps
When you are looking at gaps on a stock chart, the most importantthing that you want to know is this:
Was this gap caused by the amateur traders buying or sellingbased on emotion?
Or...
Was this gap caused by the professional traders that do not makeemotional decisions?
To figure this out you have to understand this one importantconcept first. Professional traders buy after a wave of selling hasoccurred. They sell after a wave of buying has occurred.
Amateur traders do the exact opposite&033 They see a stockadvancing in price and are afraid that they will miss out on themove, so they pile in - just when the pro's are getting ready tosell.
Here is an example of a gap caused by amateur traders...
See how this stock gapped up after a wave of buying occurred?These amateur traders got emotionally involved in the stock. Theypiled in after an already extended move to the upside.
These traders eventually lost money as the stock sold off overthe next few weeks. Notice how the stock eventually did go back up- but only after a wave of selling occurred (professionalbuying).
Here is another chart:
See how this stock gapped down after a wave of selling occurred?These amateur traders got emotionally involved in the stock. Theysold after an already extended move to the downside.
Ok, so let's break this down, shall we?
If a stock gaps up after a wave of buying has already occurred,these are amateurs buying the stock - look to short.
If a stock gaps down after a wave of selling has already occurred,these are amateurs selling the stock - look to go long.
These types of gap plays usually provide great opportunitiesbecause they represent and extreme price move.
Well, there you have it...a short primer on trading gaps.
Gaps can provide nice swing trading profits but they can be alittle more tricky to trade. The advantage is that you cansometimes make big profits, quickly, and with a little lessrisk......something every trader should strive for.
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