Analyzing Chart Patterns: Gaps
A gap in a chart is essentially an empty space between one trading period and the previous trading period. They usually form because of an important and material event that affects the security, such as an earnings surprise or a merger agreement.
This happens when there is a large-enough difference in the opening price of a trading period where that price and the subsequent price moves do not fall within the range of the previous trading period. For example, if the price of a company's stock is trading near $40 and the next trading period opens at $45, there would be a large gap up on the chart between these two periods, as shown by the figure below.
Gap price movements can be found on bar charts and candlestick charts but will not be found on point-and-figure or basic line charts. The reason for this is that every point on both point-and-figure charts and line charts are connected.
It is often said when referring to gaps that they will always fill, meaning that the price will move back and cover at least the empty trading range. However, before you enter a trade that profits the covering, note that this doesn't always happen and can often take some time to fill.
There are four main types of gaps: common, breakaway, runaway (measuring), and exhaustion. Each are the same in structure, differing only in their location in the trend and subsequent meaning for chartists.
As its name implies, the common gap occurs often in the price movements of a security. For this reason, it's not as important as the other gap movements but is still worth noting.
|Figure 2: Common Gap|
These types of gaps often occur when a security is trading in a range and will often be small in terms of the gap's price movement. They can be a result of commonly occurring events, such as low-volume trading days or after an announcement of a stock split.
These gaps often fill quickly, moving back to the pre-gap price range.
A breakaway gap occurs at the beginning of a market move - usually after the security has traded in a consolidation pattern, which happens when the price is non-trending within a bounded range. It is referred to as a breakaway gap as the gap moves the security out of a non-trending pattern into a trending pattern.
|Figure 3: Breakaway gap|
A strong breakaway gap out of a period of consolidation is considered to be much stronger than a non-gap move out. The gap gives an indication of a large increase in sentiment in the direction of the gap, which will likely last for some time, leading to an extended move.
The strength of this gap (and the accuracy of its signal) can be confirmed by looking at that volume during the gap. The greater the volume out of the gap, the more likely the security will continue in the direction of the gap, also reducing the chances of it being filled.
While the breakaway gap generally doesn't fill like the common gap, it will in some cases. The gap will often provide support or resistance for the resulting move. For an upward breakaway gap, the lowest point of the second candlestick provides support. A downward breakaway gap provides resistance for a move back up at the highest price in the second candlestick.
The breakaway gap is a good sign that the new trend has started.
Runaway Gap (Measuring Gap)
A runaway gap is found around the middle of a trend, usually after the price has already made a strong move. It is a healthy sign that the current trend will continue as it indicates continued, and even increasing, interest in the security.
|Figure 4: Runaway (or measuring) gap|
After a security has made a strong move, many of the traders that have been on the sideline waiting for a better entry or exit point decide that it may not be coming and if they wait any longer they will miss the trade. It is this increased buying or selling that creates the runaway gap and continuation of the trend.
Volume in a runaway gap is not as important as it is for a breakaway gap but generally should be marked with average volume. If the volume is too extreme, it could signal that the runaway gap is actually an exhaustion gap (discussed further in the next section), which signals the end of a trend.
The runaway gap forms support or resistance in the exact same manner as the breakaway gap. Likewise, the measuring gap does not often fill, and there's cause for concern if the price breaks through the support or resistance, as it is a sign that the trend is weakening - and could even signal that this is an exhaustion gap and not a runaway gap.
This is the last gap that forms at the end of a trend and is a negative sign that the trend is about to reverse. This usually occurs at the last thrusts of a trend (typically marked with panic or hype), but can also be the point when weaker market participants start to move in or out of the security.
The exhaustion gap usually coincides with an irrational market philosophy, such as the security being touted as "a can't-miss opportunity" or conversely as something to "avoid at all costs".
|Figure 5: Exhaustion gap|
To identify this as an exhaustion gap or the last large move in the trend, the gap should be marked with a large amount of volume. The strength of this signal is also increased when it occurs after the security has already made a substantial move.
Because the exhaustion gap signals a trend reversal, the gap is expected to fill. After the exhaustion gap, the price will often move sideways before eventually moving against the prior trend. Once the price fills the gap, the pattern is considered to be complete and signals that the trend will reverse.
One of the most well-known gap patterns is the island reversal, which is formed by a gap followed by flat trading and then confirmed by another gap in the opposite direction. This pattern is a strong signal of a top or bottom in a trend, indicating a coming shift in the trend.
|Figure 6: Island reversal pattern|
Above is an example of an island-bottom reversal that occurs at the end of a downtrend. It's formed when an exhaustion gap appears in a downtrend followed by a period of flat trading. The pattern is confirmed when an upward breakaway gap forms in the price pattern.
The size of the trend reversal or the quality of the signal is dependent on the location of the island in the prior trend. If it happens near the beginning of a trend, then the size of the reversal will likely be less significant.
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