A gap happens when a financial instrument’s price makes a sharp move either to the upside or downside, skipping over certain prices in the process. Visually speaking, a gap creates a hole, or a void, on a price chart.
Gaps often are created during earnings announcements, surprise corporate news for a particular company, when analysts upgrade or downgrade a particular stock, when a company launches some new product or amid far-reaching economic or political events. Whatever the reason, the news typically breaks when the market is closed. The result is buying or selling pressure before and at the start of the next session’s trading that causes the instrument to open at a price outside the range of the previous day.
Gaps can occur in either direction:
- Gap up: Occurs when the current day’s low is greater than the previous day’s high. On an interim basis, a provisional gap up forms when the current day opens above the previous day’s high.
- Gap down: Occurs when the current day’s high is less than the previous day’s low. On an interim basis, a provisional gap down forms when the current day opens below the previous day’s low.
Consider the chart “Bite out of Apple” (below). On Nov. 16, 2012, Apple closed at $527.67 per share. On Nov. 19, it opened at $540.62. Because no shares changed hands between $527.67 and $540.62, a provisional gap of $12.95 per share formed. In this case, the provisional gap held, as the open also was near the low of the day. Similarly, on Dec. 3, Apple closed at $586.19, and on Dec. 4, it gapped down to $581.79. Again, the gap held, and the market traded lower, establishing a gap of $4.40 per share.
Gaps can be placed into four different groups.
Breakaway or breakout gaps occur in the beginning of the trend. These give trader an indication that a new trend is emerging. This is the most potentially profitable gap for trading purposes. Breakaway gaps may not get filled on subsequent trading days, and even if they do it takes a long time for price to return to the area of the gap. After identifying the breakaway gaps, a trader should go long or short in the stock with a stop loss at the low of the day of the gap. Maintain a trailing stop loss once price moves in the position’s favor.
Consider an example found in India’s Sensex, a value-weighted index based on 30 of India’s largest stocks. As seen in “Break and run” (below), Sensex formed a breakaway gap on May 18, 2009, when the market opened at 13,479. The previous trading day, May 15, closed at 12,173. This massive gap occurred after an election that the market considered economically favorable and, with the foundation of those fundamental underpinnings, it was a clear indication that a new trend was starting. In such a scenario, traders were well-advised to go long Sensex with a stop loss of 13,479 and a target of 8% to 10%.
Continuation gaps occur during the ongoing trend, and signal a rush of buyers or sellers who share a common belief in the underlying stock’s current direction. After identifying a continuation gap, traders should enter in the direction of the current trend or consider adding to existing positions. A stop loss should be placed at the low (in the case of a long trade) of the day of the gap. A trailing stop loss should be maintained as price moves in the trader’s favor.
There’s a good example of the continuation gap in the SPDR Financial exchange-traded fund (XLF). As seen in “Gap and go” (below), XLF began its uptrend move with a breakaway gap in January 2013. It then formed a continuation gap on March 5, when the fund opened at 17.90 vs. the previous trading day’s close of 17.79. Because the gap occurred in the direction of the existing trend, it qualified as a continuation gap. As such, a trader should have gone long XLF with a stop loss at 17.90 and a profit target of 4%-5%. In this case, tight risk control would be prudent because the signal comes in the wake of a significant move higher.
Exhaustion gaps occur at the end of a trend. In the case of an uptrend, price makes one last attempt to move higher; however, the trend is exhausted, and the higher price cannot be sustained. Similarly, in downtrends, prices make one last attempt to form a new low. As the trend gets exhausted, lower prices are not sustained and value buying emerges, pushing stock prices higher.
As seen in “Cat back” (below), Caterpillar Inc. formed an exhaustion gap on Feb. 1, when the stock opened at $99.00 per share compared to the previous trading day’s close of $98.39. CAT made one last attempt to make a new high of $99.70, but the next day it gave up all the gains and started a fresh downtrend. While an exhaustion gap is better used as a signal to liquidate existing positions, it also can be used to establish new trades. This should be done with care, though, because of the ease of mistaking continuation gaps for exhaustion gaps. You’ll want significant confirmation from price or other indicator readings before taking a new trade against the previous trend.
Common gaps are the last type of gap we’ll mention. These generally occur in illiquid trading instruments. They are just a gap that means nothing in a technical analysis sense.
Filling the gap
A common saying in investing is “gaps were made to be filled.” While this is not always true, in time many gaps indeed are filled. This simply means that price returns to the area of the gap on subsequent bars to trade within the price range of the gap.
One example from recent price action occurred in the euro 60-minute chart (see “Mind the gap,” below). The market gapped down to 1.29 on March 18 because of the Cyprus crisis. By March 25, however, the euro had rallied following the approval of the bailout. The euro traded within the price range of the large gap down before it subsequently broke lower again. An astute trader might have kept this gap in mind while keeping an eye on political developments, identifying the upper end of the gap’s range as a likely target for an upward swing.
When provisional gaps are filled within the same trading day on which they occur, this is referred to as fading, which can be used by intraday traders as a trade signal. The logic behind fading is that once the financial instrument starts the gap-filling process, it rarely will stop because there is often no immediate support or resistance within the gap’s range.
This happened on a 15-minute chart for the Nifty 50 — an index of the top 50 stocks on India’s National Stock Exchange — on March 25. The Nifty opened with a gap higher at 5708 due to positive global cues. It made a high of 5717 in early trading and then fell into a consolidation pattern. Astute traders would anticipate the gap open to be filled and use the 15-minute high of 5717 as a stop loss, shorting the market with the target of 5650 (the previous day’s close). The target was eventually achieved as the Nifty filled the gap to complete the fading process.
Gap trading strategies rely on context-specific criteria to enter and exit. It is an uncomplicated approach if properly employed and offers opportunities for quick profits. While you will not capture either the top or bottom of a stock’s price range on a particular move, you will be able to profit in a structured manner and minimize losses. Stops are recommended, as well as confirmation from complementary technical tools, such as pivot analysis and oscillators.
Bramesh Bhandari writes at www.brameshtechanalysis.com and provides online tutoring on technical analysis. He can be reached via email at email@example.com.