Types and Characteristics of Trading Gaps

Gaps are a common occurance in the markets. Everyday there is always at least one stock that has gapped up or down when the market opens. Why? As long there is some event happening somewhere between the market close of the previous day to the opening of today, there will be gaps. Even if the markets eventually move little by little toward the inevitable 24-hour format, there will always be gaps. After all, somewhere around the world, there is some event happening during the weekends as well. Plus, there is always an excited group of investors who making a big deal out of something or even for no reason unknown to the rest of us. So, gaps are a fact of life and there is no avoiding it. The best thing is to take it in stride and learn how to profit from it.

There are three different types of gaps: Breakaway, Runaway and Exhaustion gaps. Each of these gaps appear at a different cycles of the markets.

Breakaway gaps occur when a stock has been in a consolidation stage; instead of a normal market-session move, it breaks out with an opening gap. Normally, these gap in the same direction before to the consolidation stage. There is one caveat: when the breakout happens, it can be in either direction. This gap is trickier than the others because the intent of direction is unclear.

In the chart example above, the market was going through a correction. When it finally finished consolidating (a symmetrical triangle pattern), it broke out with a gap to the upside to end the correction period.

As for Runaway gaps appear when the stock has been trending for some time. Instead of a normal move up during market hours, they open with a gap in continuation of the dominant trend. It shows there is more interest in the stock, possibly by some positive news to further boost the investors' eagerness to own it. Runaway gaps are also called Measuring gaps because they are often used as a centering point of measurement from the beginning of the trend to the gap, then from the other side of the gap to measure the next likely level where it would reach.

The chart below shows the prevailing trend, moving steadily upward. Along comes the opening gap, pushing in the same direction higher, not even a moment's pause or pullback until much later in the trend.

Below is the example of how a Runaway gap is also used as a Measuring tool. When the gap has been identified, the measurement is taken from the beginning of the trend (61.98) up to the bottom of the gap (87.08). From that distance, it is used to measure how far the prices will likely to continue. So the measured target starts at the upper part of the gap (102.64) to the expected level above it. In this example, the target was 130.27. This is a very powerful and easy-to-apply concept which can be used to find profitable trades.

The last type of gaps is the Exhaustion gaps. These occur when the market has been trending for a long period of time, normally after a bull market or bear market that as been lasting for a few years. When it appears, there is a period of slowing of the trend slowing, or period of consolidation. They usually appear near tops or consolidation areas after strong trends. Many times, the Exhaustion and Breakaway gaps are mistaken for one another. Depending on the location and whether or not it was an up gap or a down gap. The Exhaustion gap is an up gap appearing in the market tops, and a down gap in market bottoms. As for the Breakaway gaps, they are up gaps in market bottoms (and from consolidations) and down gaps on market tops (and from consolidations).

Below is example of each to better identify the difference. The market has been forming what look like a top, with the symmetrical triangle consolidation. Triangles are usually trend continuation patterns, but as the chart shows, the gap was break away from the pattern to the downside. This is a breakaway gap. After that gap, YHOO attempted to push prices up again with an up gap. The prices gapped up to a new high, then turned around immediately the same day. Then the next following days, the prices filled the gap, confirming that the previous gap and the direction of the market (now downtrend) are real. The Exhaustion gap was at last identified as such when considering the surrounding price action. The action created an island reversal.

The example below is the exhaustion gap (down) at market bottom. The market has been trending down with determination. Finally, a blow-off came with a big gap down, but there were no more selling. The next few days show the market stabilizing, even some buying. Finally, more buying pushed the market higher, ending the market bottom.

Knowing where the gap is located in the chart can quickly help identify what type of gap it is. These gaps give clues to the strength or weakness of the stock since they are usually turning points in the market direction. Paying extra attention to them can provide unique opportunities to trade with the right trend (or reversals) and profit from them. The next article will discuss the tactics in entering and exiting in trading these gaps.

By Larry Swing