A gap is a capital market term, used to describe discontinuation in a price chart caused due to change in market fundamentals when the market is closed. If the price of an asset significantly rises or falls from the previous day’s closing without any trade taking place in between, a gap occurs. It can occur due to significant market news to sway investors’ sentiment either positively or negatively like, earning calls after-hours.
Gaps are common occurrences, but not all of them are of equal significance. Experienced traders know which gaps to take note of and which to ignore. Mainly, gaps in stock market are categorized into four types. Check them out below.
Types of gaps
Gaps are easy to spot but determining its importance and interpreting it is what needs knowledge and practice. Here are the four types of gaps that occur in a price line.
Common gaps are also called trading gaps or area gaps. Usually caused by regular market forces and don’t require a special event. As the name suggests, these are common occurrences and non-eventful. So, these also get filled up as quickly, meaning the market retrace after a few days or weeks to its original level.
In a price chart, a common gap appears as a non-linear jump or drop from one point to the next.
How will you identify a common gap? There is no significant market news that can cause a market rally, and these gaps are usually smaller in size. Common gaps get filled up as fast as they appear.
It occurs when the price tries to break away from the congestion area. To understand breakaway gaps better, we must understand what congestion area is. 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. Similarly, the lowest point, when approached from above, refers to as the support level. 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.
When a breakaway gap occurs volume of the stock should also pick up, preferably after the gap happens to conform the direction change. A new support level is created where the market breaks out. Conversely, the new resistance level is adjusted where the trend breaks downward. Breakaway gaps, unlike common gaps, when appears, usually take a longer time to fill up.
A good breakaway gap happens when it is associated with the classical price chart.
Runaway gaps can happen in both uptrend and downtrend, it usually is a representation of a sudden change in interest or perception about a stock among traders, accompanied by a shift in demand to spike buying or selling.
Runaway gap, when associated with an uptrend indicates a change in traders’ interest in the stock. Traders, who might have missed the previous uptrend may go for a frenzied buying spree after realizing that a retracement might not happen. This cause the trade volume and price to shoot up suddenly and significantly.
Similarly, a runaway gap in a downtrend is a representation of excess liquidity in the market. It may lead to a downward spiral. Seller may panic and sell the stocks, which might cause the stock price to dive lower.
Traders use a concept of measuring the gap to decide how long the trend will continue. It usually happens in the middle of a trend.
As the name suggests, it occurs at the end of a prolonged uptrend or downtrend, indicating a trend change. It is often associated with a rise in price along with an increase in volume. Exhaustion gaps can be mistaken for runaway gaps. To distinguish between the two, traders compare both price and quantity. If both price and volume increase, it is called an exhaustion gap.
Check out the chart below. Notice that the price rise is accompanied by an increase in volume, which is why it is an exhaustion gap.
To trade efficiently, traders should be able to identify and interpret gaps correctly. Even though they are common in daily trade charts, they aren’t free from limitations. A critical concept that associates with gaps is ‘filling’. It is a concept where market readjusts to the price level nullifying the sudden change caused by the gap.
Failing to identify a gap or reacting to it may cause one to miss an opportunity to exit or enter a market, which means it weighs heavily on profit or loss from a trade.