What Is a Gap?

A gap is an area discontinuity in a security's chart where its price either rises or falls from the previous day’s close with no trading occurring in between. Gaps are common when news causes market fundamentals to change during hours when markets are typically closed, for instance an earnings call after-hours.

Key Takeaways

  • A gap is a discontinuous space in the price chart of an asset or security, often occurring between trading hours.
  • There four different types of gaps – Common Gaps, Breakaway Gaps, Runaway Gaps, and Exhaustion Gaps - each with its own signal to traders.
  • Gaps are easy to spot, but determining the type of gap is much harder to figure out. 

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.

Gapping occurs when the price of a security or asset opens well above or below the previous day’s close with no trading activity in between. Partial gapping occurs when the opening price is higher or lower than the previous day’s close but within the previous day’s price range. Full gapping occurs when the open is outside of the previous day’s range. Gapping, especially a full gap, shows a strong shift in sentiment occurred overnight.

Some traders make it a strategy to profit from playing the gap when such a situation occurs.

The Difference Between Different Types of Gaps

There are some fundamental differences between the different types of gaps: – Common Gaps, Breakaway Gaps, Runaway Gaps, and Exhaustion Gaps.

  • In general, there is no major event that precedes this type of gap. Common gaps generally get filled relatively quickly (usually within a couple of days) when compared to other types of gaps. Common gaps are also known as "area gaps" or "trading gaps" and tend to be accompanied by normal average trading volume.
  • A breakaway gap occurs when the price gaps above a support or resistance area, like those established during a trading range. When the price breaks out of a well-established trading range via a gap, that is a breakaway gap. A breakaway gap could also occur out of another type of chart pattern, such as a triangle, wedge, cup and handle, rounded bottom or top, or head and shoulders pattern.
  • A runaway gap, typically seen on charts, occurs when trading activity skips sequential price points, usually driven by intense investor interest. In other words, there was no trading, defined as an exchange of ownership in a security, between the price point where the runaway gap began and where it ended.
  • An exhaustion gap is a technical signal marked by a break lower in prices (usually on a daily chart) that occurs after a rapid rise in a stock's price over several weeks prior. This signal reflects a significant shift from buying to selling activity that usually coincides with falling demand for a stock. The implication of the signal is that an upward trend may be about to end soon.

Each type of gap has certain consequences for traders. 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.

Example of a Gap

In the historical 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. 

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.