Gap trading is a popular method in stock trading, where traders try to profit from short-term price movements that arise from gaps in the price history. A gap is the difference between the opening price and the previous closing price, in which no trading activity takes place. There are four types of gaps that can be used in this trading strategy: breakaway gaps, exhaustion gaps, common gaps, and continuation gaps (also known as runaway gaps). In this article, we will provide a detailed overview of each type of gap to help you understand and successfully apply this trading strategy.
Breakaway Gaps
What is a Breakaway Gap?
A breakaway gap is a term from technical analysis that characterizes a strong price movement through a support or resistance level. Unlike an intraday break, the price breaks away from the support or resistance through a gap. Breakaway gaps are often observed at the beginning of a trend, when the price moves out of a trading range or after a trend reversal.
Understanding Breakaway Gaps
A breakaway gap occurs when the price breaks out of a support or resistance area, as established during a trading range. A breakaway gap occurs when the price breaks out of a well-established trading range through a gap. A breakaway gap can also arise from another chart pattern, such as a triangle, wedge, cup and handle, rounded bottom or top, or a head and shoulders pattern.
Breakaway gaps are usually associated with the confirmation of a new trend. For example, the previous trend may have been downward, the price then forms a large cup-and-handle pattern, and then has a breakaway gap above the handle. This would confirm that the downward trend has ended, and the upward trend is underway. The breakaway gap, which indicates a strong conviction of buyers, is an indication that, in addition to the breakout from the chart pattern, there is the potential for further upward movement.
A breakaway gap with above-average volume or particularly high-volume shows strong conviction in the direction of the gap. An increase in volume at a breakaway gap confirms that the price is likely to continue in the breakout direction. If the volume at a breakaway gap is low, the likelihood of a failed breakout is greater. A failed breakout occurs when the price climbs above the resistance or falls below the support, but cannot hold and falls back into the previous trading range.
Gaps can occur at any time, but are more likely to occur after the announcement of quarterly earnings or other important company announcements.
Exhaustion Gaps
What is an Exhaustion Gap?
An exhaustion gap is a technical signal characterized by a downward price movement (usually on a daily chart) that occurs after a rapid rise in the stock price over several weeks. This signal reflects a significant shift from buying to selling activity, typically accompanied by decreasing demand for a stock. The signal suggests that an uptrend may be nearing its end.
Understanding Exhaustion Gaps
The principle behind an exhaustion gap is that the number of likely buyers has decreased and sellers have aggressively entered the market. The number of buyers may be largely exhausted, indicating that the uptrend is likely to come to a halt soon, as sellers take profits from a previously extended rise in the stock price. Exhaustion gaps have three distinct characteristics.
- A multi-week or multi-month uptrend of a stock's price.
- A significant gap between the lowest price of the previous day and the highest price of the last trading day.
- An above-average trading volume on the current day.
As financial instruments do not develop indefinitely in one direction, the price dynamics typically slow down at a certain point. When the price dynamics slow down, an exhaustion gap is likely to occur. Exhaustion gaps mean that the last push in one direction occurs before the security reverses. Exhaustion gaps can be difficult to identify and can easily be confused with continuation gaps (runaway gaps).
Common Gaps
What is a Common Gap?
A common gap is a price gap that can be found on a chart for an asset. These occasional gaps are caused by normal market forces and are, as the name suggests, very common. They are graphically represented by a non-linear jump or fall from one point on the chart to another point.
Understanding Common Gaps
In general, this type of gap is not preceded by a larger event. Common gaps are usually filled relatively quickly (usually within a few days) compared to other types of gaps. Common gaps are also known as "area gaps" or "trading gaps" and usually occur with a normal average trading volume.
As common gaps are relatively small, regular, and normal events in the price development of an asset, they usually do not provide any real analytical insight. These gaps are often observed in assets that experience a disruption between the market close of one day and the opening of the next day, and can be exaggerated by events that occur between Friday and Monday trading on a weekend.
Common gaps are usually what technical analysts refer to as "filled gaps." This means that the price returns to where the gap originally began, and the gap is considered filled.
Continuation Gaps
What is a Continuation Gap?
A continuation gap - also known as a runaway gap - is a frequently occurring pattern in charts. These price gaps can play an important role in identifying trends. A continuation gap occurs when a stock's price has a gap between two consecutive trading days, and this gap is in the same direction as the stock's previous trend.
Understanding Continuation Gaps
A continuation gap usually occurs when a stock has a strong trend due to news, earnings, other events, or just market conditions and this trend is resumed after a short pause. This can lead to an increase or decrease in the stock price that occurs overnight or over the weekend when the market is closed.
If you want to identify a continuation gap, you should observe the price movements of a stock over a longer period. If a stock has been moving in a certain direction for a long period and then takes a short break before continuing in the same direction, this indicates a continuation gap.
It is important to note that a continuation gap is not always a sign that the stock's trend will continue. There can also be false breakouts where the stock's price deviates in the opposite direction after the gap. Therefore, it is important to keep a deciding.
What the Trend Has to Do With Gap Types
Not every trend has a type of gap. However, sometimes trends have a gap and this is often seen early in a trend when the price makes a significant move outside a chart pattern. That is, whenever there is a significant chart pattern breakout, one could speak of a breakaway gap.
As the trend accelerates, there is often another type of gap that is called a runaway gap (also known as a continuation gap). A runaway gap occurs when the price in an established uptrend opens significantly higher than the previous closing price. During a downtrend, a runaway gap occurs when the price opens significantly lower than the previous closing price. Typically, the price moves in the direction of the runaway gap within a few weeks, sometimes even within a few days, or the next day. A runaway gap does not have to break an important support or resistance level like a breakaway gap, but it must occur in the current trend direction.
As a trend nears its end, an exhaustion gap may occur. An exhaustion gap occurs near the end of a trend and is caused by a final group of buyers who regret not buying earlier and are now rushing into the market. In a downtrend, an exhaustion gap is caused by sellers. An exhaustion gap is similar to a runaway gap, except that an exhaustion gap is typically associated with very high volume. Some runaway gaps also have high volume, but traders can also watch for exhaustion gaps that fill quickly. Since an exhaustion gap typically occurs near the end of a trend, any progress the gap made is usually wiped out within a few weeks, often within a few days (gap filled).
There are also common gaps, which occur with a small difference between the opening and closing prices. These occur frequently and are considered less significant by most traders than breakaway gaps, runaway gaps, and exhaustion gaps.