Gaps and Gap Analysis

Gaps signify a break in the action.

This is true in the world of technical analysis, where it can be a solid signal that investors can use to unearth key information on the company behind the stock – stuff that may otherwise be hidden within the stock price. While the mining of such information through gaps may be counter to the general philosophies that tend to govern technical analytics, they are nonetheless a tremendous tool that technical analysts can utilize to make solid, informed decisions.

What is a Gap?

As the name may suggest, a gap that appears in a chart is typically an empty space that manifests between one trading period and the prior trading period. These gaps generally form due to a crucial material event that ties directly back to the company behind the stock, such as a merger agreement or a surprise earnings game. Essentially, these gaps are technical analytically-driven manifestations of information that fundamental analysts may dig up through their meticulous research.

example of common gaps in stock charts

example from stockcharts.com

More specifically, gaps form when there’s a large enough difference in the opening price of a specific trading period where the price and the eventual price moves don’t land in the range of the prior trading period. For instance, let’s say a company’s stock price is trading around $35. The next trading period, this same stock opens at $40. This $5 swing would pop up on a chart in the form of a large vertical gap.

Will a Gap Show up on Every Chart?

Gaps tend to leap out at investors when they manifest. After all, when there’s a big blank spot instead of a colorful gaggle of lines, it can look rather jarring. However, investors should know that gaps will not universally form on all charts.

Gap price movements will not be found on basic line charts or point-and-figure charts. The reason for this is because every point on both of these charts will always be connected, regardless of what happens in the market. Bar charts or candlestick charts, on the other hand, don’t have this connectivity requirement, which allows gaps to show up when they happen.

While these gaps are easy to spot, these gaps tend to “fill” down the road, as the stock price will move back to cover the empty trading range. However, this action may take some time to occur, and it may not even happen at all.

Gap Types

There are four main types of gaps that investors can track. Each of these gaps hold similar structure, and the only differences they have are bound to their location with the trend and their eventual meaning.

The first of these gap types is known as the Common Gap. As the name may suggest, this particular gap shows up often within a stock’s price movements. Because of its frequency, it doesn’t demand the type of attention reserved for other gap types. When they do occur, it’s usually because a stock is trading in a range and will frequently be small relating to the gap’s price movement. This can be caused by routine events like low-volume trading days or stock splits. When they do happen, they usually “fill” quickly.

The second gap type, the Breakaway Gap, occurs at the set of a market move. Typically, investors will see this after the stock has traded in a consolidation pattern, which occurs when the price isn’t trending within a given range. It earns its name because the gap shifts the stock from a non-trending pattern to a trending pattern. In other words, the stock “breaks away” from its prior pathway.

The gap’s strength can be confirmed by the investor by observing the gap’s corresponding volume. The greater the gap’s volume, the more likely the stock will continue in the gap’s direction. This also reduces the chances of the gap being filled, an action that typically doesn’t happen as it does with a common gap.

The Runaway Gap is a gap that is located around the middle of a trend, typically after the price has already shown a strong surge. The gap itself is a healthy signal that the current trend will continue, as its presence points to a steady if not increasing interest in the stock amongst investors.

The strength of a runaway gap doesn’t necessarily correlate to volume heft. Typically, the kind of volume investors want to see on this particular gap falls into an average range. If the volume leans too heavily, it may signal the end of a trend.

To that end, a trend that is approaching its terminus may be marked by an Exhaustion Gap. This particular gap does indeed form at the end of a trend and indicates a trend reversal is on the horizon. The gap will essentially pop up when the buzz around the stock is either in hype or panic mode. However, it can also manifest when weaker market players start moving in or out of the stock.

Exhaustion gaps also tend to show up when irrational market philosophies start cropping up. If investors start hearing the experts signaling a stock as a lock to do good or a plague on a portfolio, they can pretty much prepare for an exhaustion gap. Needless to say, a proper exhaustion gap should be marked by heavy volume, as buyers and sellers will act on the hype or the panic the stock is creating.

Island Reversal: The Gap after the Gap

One thing investors may want to keep an eye out for is a pattern known as an island reversal. This is created by a gap followed by flat trading, which is confirmed by a gap swinging in the opposite direction. This unique double gap is a solid indicator of a trend’s apex, and it can be a handy way for investors to spot reversing trends.

As a whole, gap analysis could provide insight into stock movement that may not be as readily visible in other forms of technical analysis. As such, it can be a great asset for technical analysts that want to use charts to craft a complete stock trading strategy.

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