THEORY OF PRICE GAPS

THEORY OF PRICE GAPS

What is a ‘Gap’ in technical analysis?

A gap is an area on a price chart in which there were no trades. It is easy to see gaps if you take candle stick charts. Let us try to understand gaps in another way. The fluctuations in stock prices are coherent in nature. That means that the price rises or falls gradually.  Thus, in rising scrip, if on one day the low was Rs 100 and the high was Rs 135, on the next day the low would be Rs 130 and the high Rs 140. Here, the low for the next day falls within the high-low range of the previous day. But suppose for the second day, the low was Rs 145 and the high Rs 150. Then, the low for the next day has fallen above the previous day High-Low range, or it was higher than the previous day’s high. So, when one draws bar charts showing High-Lows every day, there would be a discontinuity, termed as a ‘Gap’ in technical theory. An interesting feature of Price gaps is that it gets filled within a short amount of time. That is, the price would come back to fill the price gap of Rs 140 – Rs145, where there was no trade in the previous days.

In simple terms-a gap occurs when the current bar opens above the high or below the low of the previous bar. On a price chart, a space appears between the bars indicating the gap.

Types of price gaps

Gaps can be subdivided into four basic categories:

• Common Gaps
• Breakaway Gaps
• Runaway Gaps and
• Exhaustion Gaps.

Common gaps:

Common gaps are ‘common’ and ‘uneventful’. If a Gap is formed when the markets are moving in a narrow range, it is called a Common Gap.

Breakaway Gaps:

A “breakaway” gap ends a consolidation pattern and happens as prices break out. Often, they would be accompanied by huge volumes. Break-out Gaps are generally not filled for a long time, i.e. in the case of an uptrend, the price does not fall back to wipe off the gains. They may be filled as and when the prices retrace after a substantial up move. If the breakout happens to be a downtrend, the prices may not rise soon to wipe off the loss.

Runaway Gaps:

Runaway gaps are best described as gaps that are caused by increased interest in the stock. For runaway gaps to the upside, it usually represents traders who did not get in during the initial move of the up trend and while waiting for a retracement in price, decided it was not going to happen. Increased buying interest happens all of a sudden, and the price gaps above the previous day’s close. This type of runaway gap represents an almost panic state in traders. Also, a good uptrend can have runaway gaps caused by significant news events that cause new interest in the stock. Runaway gaps can also happen in downtrends. This usually represents increased liquidation of that stock by traders and buyers who are standing on the sidelines. These can become very serious as those who are holding onto the stock will eventually panic and sell – but sell to whom? The price has to continue to drop and gap down to find buyers. So, in either case, runaway gaps form as a result of panic trading.

Exhaustion Gap:

An “exhaustion” gap occurs at the end of a price move. If there have been two or more gaps before it, then this kind of gap should be regarded very skeptically. A genuine “exhaustion” gap is filled within a few days to a week. It is generally not easy to distinguish between the Runaway and Exhaustion Gaps. Experience in reading charts will help in due course. The best clue available is that Exhaustion Gaps are not the first Gaps in the chart, i.e. they follow the Runaway Gaps and usually occur when the runaway Gap is nearing completion. Exhaustion Gaps do not indicate whether the trend will reverse, they only call for a halt in the price movement.
This completes our discussion on gaps. I hope it has filled in some gaps in your trading knowledge. Here are some additional hints :-

• A gap has relevance only to a daily or short term trader.
• On spotting a gap in a daily chart, immediately question yourself as to which of the four kinds of gaps it is.
• Generally, short-term trades should be in the direction of the gap. The larger the gap and the stronger the volume, the more likely it is prices will continue to trend in that direction.
• A “breakaway” gap provides an immediate buy point, particularly when it is confirmed by heavy volume.
• The third upside gap raises the possibility of an “exhaustion” gap. Traders should look for the gap to be filled in approximately one trading week. If the gap is filled and selling pressure persists, then that issue should be shorted. If the gap is the third one to the downside, then traders should be alert for a buy signal.
• Gaps are powerful signals to make profits if used intelligently. They should not be acted on in isolation. View the gap within the context of the other technical results.