What Is a Stock Gap? 4 Main Types of Gaps, Example, and Analysis

What Is a Stock Gap? 4 Main Types of Gaps, Example, and Analysis

A stock 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.

Understanding a Stock Gap
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 opening is outside of the previous day’s range. Gapping, especially a full gap, shows a strong shift in sentiment that occurred overnight.

There are limitations despite gaps being easy to spot. The glaring flaw is one's own ability to identify the different types of gaps 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.

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

• Common Gap:
  
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In general, there is no major event that precedes a common 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.

Common gaps occur in markets without a strong trend. They are not followed by new highs or new lows and are quickly closed in subsequent days' trading.

Some gaps are caused by events and should be ignored:

-Ex-dividend gaps occur as the price adjusts on the day after a dividend becomes payable;
-New share issues
-Expiry of futures contracts.

• Breakaway Gap:
  
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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.

How this gap is working
Breakaway gaps are normally accompanied by heavy volume and occur when prices break out of a trading range. They are usually followed by a series of new highs in an upside breakout or, a series of new lows in a downside breakout, and are seldom closed.

Trading Rules
-Upside Breakaway
If the gap is accompanied by heavy volume, go long and place a stop-loss at the lower end of the gap.

-Downside Breakaway
If the gap is accompanied by heavy volume, go short and place a stop-loss at the upper end of the gap.

• Runaway Gap:
  
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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 security, between the price point where the runaway gap began and where it ended.

Trading Rules
If volume is strong (up at least 50%), trade as for breakaway gaps. Enter the trade early and wait for new highs (or new lows in a down-trend) to confirm the pattern. If there are none in the next few days then exit immediately — it could be an exhaustion gap.

• Exhaustion Gap:
  
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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.

Trading Rules

-Upward Exhaustion Gap
Sell short (or close your long position) and protect yourself with a stop above the last high.

-Downward Exhaustion Gap
Go long (or close your short position) with a stop below the latest low point.

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 other gaps may signal a reversal or continuation of a trend.

What Is Price Gap Risk?
Price gap risk is the risk that a security's price will fall or increase dramatically from a market close to a market open, without any trading in between. Traders should plan for price gap risk, such as by closing out orders at the end of the day or putting in stop-loss orders.


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