What Is a Gap?
A gap is an area of a chart where a security's price either rises or falls from the previous day’s close with no trading occurring in between. In the example below, Netflix’s stock gapped higher on January 15, 2019, after the company announced it was raising the cost of its monthly subscription.
What Does A Gap Tell You?
Gaps typically occur when a piece of news or an event causes a flood of buyers or sellers into the security. It results in the price opening significantly higher or lower than the previous day’s closing price. Depending on the kind of gap, it could indicate either the start of a new trend or a reversal of a previous trend. In the example below, Amazon.com Inc. (AMZN) stock gaps higher on October 27, 2017, rising sharply from the previous days close after months of sideways consolidation. The stock's gain is accompanied by a massive increase in volume, confirming a breakaway gap. It is the start of a new trend higher in Amazon’s stock, which goes on to rally from $985 to $2,050 by September 2018.
In the next example, Alphabet Inc.’s (GOOGL) chart shows a runaway gap. Alphabet’s stock was already increasing in April 2017 when it gapped sharply higher, continuing its previous uptrend.
The Difference Between Different Types of Gaps
There are some fundamental differences between the different types of gaps. For example, reversal or breakaway gaps are typically accompanied by a sharp rise in trading volume, while common and runaway gaps are not. Additionally, most gaps occur due to news, or an event such as earnings or an analyst's upgrade/downgrade. Common gaps happen more regularly and do not always need a reason to occur. Also, common gaps tend to get filled, whereas the other two gaps may signal a reversal or continuation of a trend.
Limitations of Gaps
There are limitations despite gaps being easy to spot. The glaring flaw is one's own ability to identify the different types of gap that occur. If a gap is misinterpreted, it could be a disastrous mistake causing one to miss an opportunity to either buy or sell a security, which could weigh heavily on one's profits and losses.