Updated: Nov 24
In the world of technical analysis and stock trading, gaps are areas on a price chart where the price of a stock (or another financial instrument) moves sharply up or down, with little or no trading in between. A gap stands for a discontinuity in the price graph of an asset. There are several types of gaps, each with its own significance. Let us explore the four main types: Exhaustion Gap, Runaway Gap, Breakaway Gap, and Common Gap.
1. Exhaustion Gap Definition: An Exhaustion Gap occurs near the end of a price pattern and signals a final attempt to hit new highs or lows. This type of gap is typically found after the fact, as it appears as a gap that is followed by a significant reversal in price.
Example: Imagine a stock that has been in a steady uptrend for several weeks. One morning, it opens significantly higher than its earlier close, but this is followed by a rapid decline over the next few days, bringing the price back to, or below, the pre-gap level. This gap up followed by a swift reversal is characteristic of an exhaustion gap.
2. Runaway Gap (or Continuation Gap) Definition: A Runaway Gap is found around the middle of a trend and signals a continuation of that trend. This type of gap usually occurs in a strong bull or bear market that is powered by intense investor interest.
Example: Consider a stock in a strong uptrend. The stock suddenly gaps up on particularly high volume, but unlike the exhaustion gap, the price continues to move in the direction of the gap (upwards in this case), showing that the trend is still strong and likely to continue.
3. Breakaway Gap Definition: A Breakaway Gap occurs at the end of a price pattern and signals the beginning of a new trend. This gap is often seen at the completion of an important price pattern, such as a head and shoulders or a triangle.
Example: A stock has been trading in a tight range for several weeks, forming a consolidation pattern. One day, it gaps up significantly, breaking out of the pattern. This gap-up, especially if accompanied by high volume, can signal the start of a new uptrend.
4. Common Gap Definition: Common Gaps are those that cannot be classified in any of the gap categories mentioned above. They are often filled quickly (meaning prices return to the pre-gap level) and do not have much analytical significance.
Example: A stock might gap up or down slightly on a regular trading day, but then the price action for the rest of the day brings it back to near where it opened. These gaps are often caused by the normal ebb and flow of trading and don't show any significant price movement. Key Points to Remember
Volume: The significance of a gap is often confirmed by the trading volume. Higher volume suggests a stronger signal.
Context: Always consider the overall trend and market conditions when analyzing gaps.
Reversal: If a gap is followed by a significant move in the opposite direction, it might show a potential reversal.
Technical Analysis: Gaps are just one tool in technical analysis. They should be used in conjunction with other methods for a more comprehensive analysis.
Gaps can be powerful tools for traders and investors, but they need careful analysis and should not be used in isolation.