What does the word Gap mean?
A gap can be defined as an empty space between two things. It can also be defined as an unfilled space or void within a continuous process. We can find such gaps everywhere. A gap can also mean a difference between the two. We use words like an age gap, time gap, generation gap, trade gap and the like.
In the stock market also the Gap is meant as a visible difference between the two. Gap carries big significance to the traders. This article covers the significance of Gap in the stock market and how a trader can take advantage of it.
What is a Gap in Stock Market Charts?
The Gaps were probably the earliest noticeable pattern or lack of pattern that were visible to the technical analysts. The reason for visibility lies in the character of charting.
Technical analysis charts were created at the beginning by plotting the historical price movement of a stock over a period of time. Therefore, technical analysis is based more on visual pattern formation of price action than any scientific calculation. During a Gap formation, the price jumps from one point to another without showing continuity, leaving a gap or void behind. This lack of continuity left a space on the chart, which was noticed even during the earliest days of technical analysis.
Here is a diagram that shows Gaps in price movement. In Fig. 1 we can see the Gaps are marked with blue elliptical marks. We can see that the price action is missing there and there is no continuous pattern of candlesticks there.
We can see why this is visually conspicuous. In the chart of 15 min. chart of Nifty on 06.05.2022., these price gaps are visible prominently. A glance at this chart of Nifty (from 29.04.22 to 09.05.22) shows three such gaps, as marked in blue. A trader or analyst will never miss that.
While explaining the price chart we use some common terms to identify price movement.
Gap Up: A Gap Up in price occurs when a candlestick’s lowest price point is above the previous candle’s highest price, leaving a gap or void behind. In Fig.1 the middle blue circle indicates a Gap Up price.
Gap down: On the contrary, a Gap Down in price occurs when a candlestick’s highest price point is below the previous candle’s lowest price, leaving a gap or void behind. In Fig.1 the blue circle on the left and the right of the chart indicates a Gap Down price.
4 Major Gaps with Detailed Analysis
Many types of Gaps can be found. Some Gaps are significant for traders and open real good trading opportunities for traders while some others are not so significant. In this section, we are going to discuss them all.
Breakaway Gap / Breakout Gap
The Breakaway or Breakout Gaps usually occur at the beginning of a trend. These types of Gaps are considered to appear to be the most profitable trading opportunity for a trader. A Breakaway Gap, as the name implies, usually starts after a congestion period, beginning a potential new trend. Riding such trends is found to be a profitable opportunity for a trader.
This Gap in technical analysis terms is closely associated with strong price movement through support or resistance zones. These support or resistance zones can be identified as established trading ranges.
The Breakaway or Breakout Gap occurs when the price breaks out from these established trading zones.
In addition to this, the Breakout or Breakaway Gap may also occur when the price breaks out from other chart patterns like the Head and Shoulder pattern, the Cup and Handle pattern, the Wedge pattern, Triangle (ascending or descending), Rounded Top, Rounded Bottom.
There is an important point to notice. These Breakaway Gap movements become stronger when the high stock volume is associated with these moves. A price breakout with high volume indicates that traders have conviction with this move. Riding such patterns give trading opportunities.
The Common Gap is also known as Pattern Gap, Area Gap or Temporary Gap. This type of gap tends to occur most frequently. This type of gap is characterized by the fact that there is no strong price movement that follows this type of gap.
This is a very temporary or short-term gap. In the charts Fig. 1 and Fig. 3, we can see these types of short-term gaps. From the charts, it is evident that after a short period, the Common Gaps are usually filled up leaving no trace of the gap.
These types of gaps are found in illiquid stocks or future and options data. In an illiquid instrument, the trading interest is very low due to the presence of very few traders. We can find frequent gaps in bid and ask data. Such gaps give rise to frequent gaps in candlestick charts.
The Exhaustion Gaps usually occur at the end of a trend. The occurrence of such gaps may indicate the end of an existing trend.
As the name suggests, in case of an uptrend, at some point in time, the buyers ultimately get exhausted having no steam left in them. At such times, the buyers make one last attempt to push the market.
But due to the absence of enough buy volume, the higher price could not be sustained, resulting in a drop in price. At that time, the bears, sensing the opportunity of a ripe kill, come with vengeance, rapidly pushing the price.
Bulls succumb to this pressure, resulting in a sudden drop in price. This phenomenon is reflected in the price movement patterns and the bearish candles open with a gap down price.
Similarly, in the case of a continuous downtrend, at one point, the bears get exhausted and no more selling pressure can be applied on their part. The price movement becomes sluggish at first, and the stock can not move further downwards.
Then the buyers come back in force and start pushing the stock upwards. The absence of enough sellers results in a sudden surge in price northwards. This sudden price movement northwards results in a price surge, creating a gap up in the price chart.
Though the Exhaustion Gap is indicative of the end of a trend. But this pattern does not tell us to initiate a new trading position. Rather, the appearance of an Exhaustion Gap helps the trader to exit from the existing position.
Trading Exhaustion Gaps are very difficult. As we all know, an Exhaustion Gap indicates the potential end of a trend. But during the formation of this Gap, it is very difficult to distinguish this gap from a Runaway Gap.
Secondly, as it is formed near the end of the existing trend, after the formation of this Gap, it may soon be filled and the price may continue according to the existing trend not allowing a trading opportunity.
Else, after this Gap was formed, the price may enter into a consolidation zone and may continue to be traded there for some time before forming a trade pattern.
Therefore it is advised not to trade the Exhaustion Gap, except to exit from the existing position.
Measuring Gap / Runaway Gap
The Measuring Gap is also known as Runaway Gap. This type of gap occurs along the midway of a trend. In many cases, we can see these gaps along the path of a strong trend when some minor corrections have already taken place but the main trend remained intact.
The Runaway Gap is known as the Measuring Gap because these gaps occur approximately in the midway of a long trend
The occurrence of such gaps may give an approximate idea to traders of how far the current trend may go.
Thus from a trader’s point of view, this gap has great significance. Starting from the beginning of the trend, if a trader can measure approximately the price movement, assuming that the Measuring Gap occurred at around 40% to 50% of the trend, a target projection may be established. The trader can assume the projected price of the stock as per the current trend.
Other Types of Gaps
When a price goes ex-dividend after the day on which the dividend is paid to the stockholders, the stock price is automatically adjusted the following day. Therefore the next day the stock opens with a gap, creating a temporary void in the price pattern. There is no significance in this gap from the trader’s point of view. But a trader should not misinterpret these gaps and get confused with another kind of gap.
The Opening Gap occurs when a stock opens with a price that is outside the range of the previous candle, usually in a daily chart. After opening, the price may continue to trade in the direction of the Gap. Or the price retraces and fills the gap created earlier. There lies no trading opportunity if the gap is filled up.
But, it is generally found that if the Opening Gap is not filled up within the first half-hour of trading, the price may not reverse and continue to trade along the direction of the gap. These create good intraday trading opportunities. Many intraday traders wait for such trading opportunities. In such cases, if the stock retraces, it is usually done to fill half of the Gap. After that, the stock may continue to trade in the direction of the Gap again. A trader should play these Gaps with strict stop loss,
Sanku (the Three Gaps Pattern)
This is a Multiple Gap pattern. Sanku is a Japanes name. Sanku occurs or the Three Gaps pattern is a typical scenario when we can find three individual gaps placed within a well-defined trend. This pattern indicates a strong price action, but usually, such price action does not sustain for long.
The Rising Three Gaps pattern occurs in an uptrend. There are three Gaps in this uptrend which are normally separated by three uprising candles. The candles lying between may be more than one in number.
Similarly, the Falling Three Gaps candle pattern is found in a downtrend. The declining Gaps are found separated by one or more falling columns.
These patterns show that the trend is nearing exhaustion. If the latest gap gets filled up by price movement in the opposite direction, it may indication of an impending reversal in the near term.
The Arbitrage Gaps represent unique trading opportunities. Tlwayshese gaps are found mostly in future and options prices, or among instruments across various markets. Traders always look for unjust pricing of future and options across various platforms. Arbitrageurs place buy orders of an instrument on one platform and sell the same on another platform to take advantage of the gap in pricing. Similarly, the trader buys one stock in say NSE and sells the same stock in BSE, if there exists a pricing gap.
This is a very successful trading strategy. Both the institutional and retail traders try to take advantage of the existing gap in the pricing of instruments. We call such a gap an Arbitrage Gap.
What is the significance of Gaps in the stock market?
Gaps present trading opportunities. The trading opportunities are created due to the nature of the Gaps. And traders always find these opportunities.
Hence it is very important for a trader to study and correctly interpret the nature of the Gap. Gap analysis presents us with many probabilities. A trader trades a Gap when the price of a stock moves in the direction of the Gap. But if the stock retraces and the gap is filled up from move from the opposite direction, that Gap is not tradeable. It is, therefore, necessary to do the right kind of Gap analysis and interpretation before committing a trade.
How to trade the Gaps?
Due to the difference in nature of Gaps, the Gap trading strategies are different for different kinds of Gaps.
The Breakaway Gaps are traded by selling or shorting the instrument and keeping stop loss a little away from the upper end of the Gap.
A Runaway or Continuous Gap in a downtrend is traded in a similar way. After placing the short/ sell order, a stop loss is kept above the upper rim of the Gap.
An Exhaustion Gap is traded when the pullback is unsuccessful. Sell the instrument and keep the stop loss above the high. If the stop loss is taken out, cover the shorts.
A Common Gap is created in the middle of a congestion period. No trading should be done.
A Breakway Gap formed in Uptrend. Place a buy order and keep the stop loss just below the lower rim of the Gap.
In a Continuous Gap, place a buy order and place stop loss just below the lower rim of the Gap.
Word of caution
It is advised to study Gap analysis thoroughly and interpret the Gap correctly before taking a trading decision. The Gaps must also be traded with tight stop loss. Except in the case of the Measuring Gaps, it is hard to fix a trade target. It is the traders’ own decision. Traders may also keep the risk/ reward ratio in mind when setting up the target price.
A study of volume during price action also helps the trader to take the right decision. Price movement accompanied by high volume usually helps to keep the momentum going. This concept is a key concept. This must be kept in mind.
Read more: How to do Trading Volume Analysis?
It is quite possible that confusion between the Measuring Gap and Exhaustion Gap can cause an investor to position himself incorrectly and to miss significant gains during the last half of a major uptrend. Keeping an eye on the volume can help to find the clue between the Measuring Gap and Exhaustion Gap. Normally, noticeable heavy volume accompanies the arrival of an Exhaustion Gap.