A gap is a change in price levels between the close and open of two consecutive days. Although most technical analysis manuals define the four types of gap patterns as Common, Breakaway, Continuation and Exhaustion.
A Gap Up occurs when the opening price is greater than yesterday’s high price.
A Gap Down occurs when the opening price is less than yesterday’s low.
Gaps in price are great because they are the picture of a strong supply and demand imbalance when you understand them. Not every gap sends the same message or represents the same opportunity.
Traders have labeled gaps depending on where it shows up on a chart.
- Breakaway Gaps – This type usually occurs after a consolidation or some other price pattern. A stock will be trading sideways and then all of sudden it will “gap away” from the price pattern.
- Continuation Gaps – Sometimes called runaway gaps or measuring gaps, these occur during a strong advance in price.
- Exhaustion Gaps – This type of gap occurs in the direction of the prevailing trend and represents the final surge of buying or selling interest before a major trend change.
Sometimes you will hear traders saying that “gaps always get filled”. This just simply isn’t true. Some gaps never get filled, and sometimes it can take years to fill a gap.
Here are some concepts and general rules about gaps. First, we generally never buy a large gap up at the open or sell short a large gap down at the open. When market makers have the chance, they will often exaggerate the gap. Also, large gaps are already extended, making the play risky. We tend to “fade” the gap initially, if played at all. Fading means to play the stock to come back into where it was. Fading a large gap up would be to go short the stock as it trades down after a large gap up.
After the initial move, Small gap up that gaps over resistance can be watched for long entries. Large gap up that gaps into resistance can be watched for short entries.
Small gap down that gaps under support can be watched for short entries. Large gap down that gaps above support can be watched for long entries.
What is “large” or “small” and what is resistance is all a matter of chart reading and interpretation. As a rule, we like to buy strength and sell or sell short weakness.
The concept of gaps is a very difficult one for most traders, even those with considerable experience.
The trend is your friend until it ends. If the market or stock keeps going up for a long time, then it gaps up, it’s profit taking time (exhaustion gap). This can be a trend reversal signal.
Small gaps are for day traders. In this day & age, day trading is very difficult (you have to compete against manipulators, machines, etc. The market can be manipulated in a very short time). Only a few can make it.