Tips on Technicals - Gaps
| Indicator type: |
Chart Pattern |
| Used to: |
Identify strong market opinion, measure potential moves, warn of pending reversals |
| Markets: |
All cash and futures, not options |
| Works Best: |
Daily and longer-term charts. 24 hour markets are less likely to show interday gaps so intraday gap analysis is more prevalent. |
| Formula: |
N/A |
| Parameters: |
N/A |
| Theory: |
A gap is simply a price level where a market does not trade1. In a rising market, a gap occurs when prices open at a higher level than the previous day's high and do not trade lower to fill the space2. The reverse is true for a falling market.
There are four basic types of gaps and they are only distinguished by their placement within the chart pattern. These are called breakaway, continuation, exhaustion and "other."
Gaps signify extreme shifts in opinion and include breakouts, reversals and increased belief in the current trend.
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| Interpretation: |
Breakaway gaps occur at the completion of an organized price pattern and usually signal the start of a significant price move. They are important because they emphasize that there was a breakout and this becomes an even stronger signal when it occurs with higher volume.
Once a rally or decline is underway, market opinion can be so strong that there is no time for normal accumulation or distribution (orderly trending). The market can simply jump to new levels immediately and this is known as a continuation gap. Because these types of gaps typically occur at the half way point of a move they are sometimes called measuring gaps. Continuation gaps can occur alone, as a series of gaps or not at all.
The last of the classified types is called an exhaustion gap because it occurs near the end of the move to signal a last push toward new highs or lows. It is sometimes to difficult to identify this type of gap because it appears in a trending market just like a continuation gap. Price action in the days immediately following the gap help the analyst determine which kind of gap it was. Whereas continuation gaps are following by a continuing strong trend, exhaustion gaps are followed by more congested, sideways market action. Such signals as inside days3 help identify which gap has occurred.
Prices usually trade back to fill the gap and, when they do, it is a good sign that the move is over. The gap represents the market "frenzy" where all participants are buying or selling at any price just to be involved. The smart money uses this activity to take profits, leaving only the weak participants left to try to push the market further.
A common reversal pattern seen with exhaustion gaps is called an "island reversal." After a market gaps (exhaustion), it usually trades for a few days in a small range. Because the market makes no progress in the direction of the trend, it can be said that the late buyers (or sellers, in a downtrend) entered the market with a high degree of emotion. Such desperation is usually the sign of the end and when this is realized in the market, prices gap in the opposite direction. The shape of the gap, congestion and reverse gap looks like an island surrounded by water. This sort of pattern usually signals a strong change in trend.
The final category for gaps does not really have a name but has been called "common" or "unclassified" gaps. These types of gaps occur within price patterns or congestion zones and are the least meaningful of all gaps. They generally signify a lack of direction in the market or lack of conviction of the market participants. News and sentiment affect these markets more than others simply because they are less liquid at that time.
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The charts above illustrate the four types of gaps. Note the difference in trading activity following continuation and exhaustion gaps. The former type is followed by strong trending while the latter is followed by consolidation.
1 In candlestick charting, a gap is known as a "window."
2 The candlestick equivalent of filling a gap is called "closing a window."
3 A "doji" pattern would be a similar candlestick pattern.
