What are Gaps?
Gaps occur when there is an empty space between two trading periods that are caused by a significant increase/decrease in price; i.e. current open is not the same as prior closing price. E.g. A stock might close at INR 500 and open at INR 510 after positive earnings. This is called as Gap-up. There are three main types of Gaps: 1) Break away 2) Run away 3) Exhaustion
How does it work?
Price charts often have blank spaces known as ‘gaps’. They represent times when no shares were traded within a particular price range. Normally, this occurs between the close of the market on one day and the next day’s open.
Gaps result from extraordinary buying or selling interest developing, while the market is closed. For example, if an earnings report with unexpectedly high earnings comes out after the market has closed for the day, a lot of buying interest will be generated overnight, resulting in an imbalance between supply and demand. When the market opens the next morning, the price of the stock rises in response to the increased demand from buyers. If the price of the stock remains above the previous day’s low throughout the day, then an up gap is formed.
Gaps appear more frequently on daily charts, where every day is an opportunity to create an opening gap. Gaps on weekly or monthly charts are fairly rare: the gap would have to occur between Friday’s close and Monday’s open for weekly charts, and between the last day of the month’s close and the first day of the next month’s open for monthly charts.
Key things to remember while trading with Gaps:
- Once a stock has started to fill the gap, it will rarely stop, because there is often no immediate support or resistance.
- The trade must always be in the overall direction of the price (check hourly charts).
- The price must retrace to the original resistance level. This will indicate that the gap has been filled, and the price has returned to prior resistance turned support.
- There must be a candle signifying a continuation of the price in the direction of the gap. This will help ensure that the support will remain intact.
- Be sure to watch the volume. High volume should be present in breakaway gaps, while low volume should occur in exhaustion gaps.