PRICE GAPS ON CHARTS
 
 
 
One of the facts about technical analysts and general public is the concept of gap. In almost every training program that we conduct, we are asked about the importance of gaps, when they will be closed, whether it is mandatory for gaps to close etc etc. In order to settle those issues we thought we would convert these frequently asked questions into a small article on Gaps.
 
A gap on a price chart is an untraded price area. It is an empty space,between the high of one trading period and the low of the very next trading period or vice versa. The trading period may be daily,occasionally weekly and rarely monthly. Gaps are easily recognized on price bar charts. Gaps cannot be seen in Closing charts or Line charts as it joins up all the closes and the gap is found between highs and lows.
 
Gaps have great significance. They tell a great deal about underlying investor activity so whenever they occur you must deduce the information they have to tell because to do so correctly is a source of great profits and, perhaps more importantly, of market timing. Gaps can be classified as common, breakaway, runaway and exhaustion gaps, each literally descriptive of their nature. Gaps also lead to the recognition and understanding of two other market reversal patterns of great significance, direction and time – one day reversal and island reversal patterns.
 
Common gaps are of limited importance and frequently tell little of future price trends. These occur on days of very light trading when what few offers of bid and ask are consummated are done so at prices removed from the previous day's price range. These gaps are invariably quickly filled in. Even though they offer no directional information they can indicate at what price you can expect the commodity or stock to trade in the ensuing hours or days of trading; it announces a price level of entry or exit that can be expected if, for other good technical reasons, you want to trade.
 
Breakaway gaps may just look like other common gaps on a price bar chart. However, this gap is created on large, often explosive volume. It is usually the beginning of a major move both in direction and price. A breakaway gap occurs after a trend pattern has been completed and heralds the birth of a new trend. The completion of the previous trend or occasionally the news of some major importance to the market attracts a mass of new buyers. To take advantage of and to satiate the new buying demand the auction opens above the previous close and the momentum of buying rapidly pushes the price higher. If the new trend is to be of major proportions the gap should not be filled in the subsequent trading days. In fact such gaps usually are not filled for some time, maybe weeks or months, very occasionally never. If in the ensuing days the gap is filled care should be taken in interpreting the significance of the gap. If the initial enthusiasm has waned so quickly it is unlikely that a sweeping new trend is underway; however, the new trend may survive but its rate of development will likely be more orderly.
 
After the surprise development of the breakaway gap and the initial enthusiasm has passed, holders and short sellers evaluate their positions and may take opportunity at this point to cover their positions or take profits and so, as this realignment occurs, prices may well fill the gap. This point sets a real test of the market's intent. If the net market opinion now considers the cause of the breakaway, be it news or rumor, to be of no lasting significance then the anticipated new trend will be aborted and a period of conflict may ensue between buyers and sellers; occasionally the original trend will be taken up.
 
Usually the underlying cause of the breakaway, after reevaluation during the gap filling period, is confirmed and causes a new wave of buying to enter the market; price and volume accelerates and the new trend becomes firmly reestablished. As this new wave of buying gets under way those investors, who remained skeptical during the gap filling period, now realize the error of their judgment and short sellers scramble to cover their positions and long traders jump aboard before the train leaves without them. This three headed buying monster let loose in the market will often cause rapid price escalation creating runaway gaps.
 
Runaway gaps may also occur immediately after a breakaway gap if the underlying cause of the initial gap was so compelling as to motivate large numbers of investors and leave very few doubters awaiting a fill period to further evaluate their positions.
 
A runaway gap frequently indicates the midpoint of the price advance of this new trend and is a good prognostic indicator. However, there may be a series of runaway gaps. A really violent dynamic develops.Skeptics believing that the trend has gone too far too quickly take up short positions, but the unfolding trend attracts new buyers and the price continues to go up and so panicking short sellers rush to cover their positions once more and these buying demands may force further gaps in the accelerating trend.
 
Eventually, and usually quite suddenly, all the short sellers have covered their positions and all but the dumb money, the stragglers attracted to the highflying market, have filled their buy orders. A final gap is created by the smart money, taking advantage of the dumb money, asking an unrealistic asking price (because of the momentum of the market) and finding the dumb money stragglers glad to pay the price. This final gap is the exhaustion gap and prices above it are short lived, often hours or less. Now buying demand is exhausted, selling finds no support and prices drop. This sign of weakness has been awaited by profit holders and now the market is awash in sell orders and the trend has reversed. In bear markets the scenario is reversed leading to the typical selling frenzy at market bottoms. Many times it is difficult to spot the exhaustion gap as the market or the stock reverses on the same day that the final gap occurs and closes below. This actually commences the reaction but only those who are keenly watching the price moves will be able to spot the final exhaustion gap soon after it forms. The gap is really between the previous day’s high or low and today’s open. The stock then trades to a new extreme (high or low as may be) and then reverses below the open to begin closing the gap.
 
The Conundrums of Gaps
 
Common gaps are easily recognized and have limited significance other than they will be soon filled. Breakaway gaps are also recognizable and can be acted upon either immediately or more prudently after confirmation of the successful development of the new trend. However, when is a runaway gap an exhaustion gap?
One can only know retrospectively but then profits may have been significantly eroded as exhaustion gaps usually lead to imminent and substantial price reversals. Exhaustion gaps rarely occur as second or third gaps. Therefore, if no key reversal day has developed after the third gap (one breakaway and two runaway gaps) place a stop loss sell or buy order, as appropriate, at the price extreme counter to the trend of the day before the gap developed (i.e. at the low of the day before the gap in a bull market and the high in a bear market), if it is not an exhaustion gap, you would not be stopped out of an on going trend. Placing the stop as advised allows for the gap to be filled without being stopped out prematurely.