A common term frequently heard in markets is gap ups and gap downs. In stock markets, a gap is an area of discontinuity in the price of a stock, where the stock price opens higher or lower than its price on the previous day’s closing, while no trading occurs in between. Such gaps are fairly common and are usually filled on a regular basis. They typically occur when an event or a piece of news causes sellers or buyers to flood the market for that stock. A gap can be an important indicator of the end of a trend or the beginning of a new one, hence identifying trading opportunities. Gap analysis requires confirmation of information that can only be obtained when the price variation manifests itself and therefore is retrospective.
Spotting Gap Ups and Gap Downs
Up and down movements in the gap occur because of price fluctuations for market security between two consecutive days and are independent of volumes. It’s important to understand the difference between two specific types of gaps; full gap up and full gap down. When the opening price of a stock is comparatively more than the high price on a preceding day, it is known as a full gap up. Contrastingly, a full gap down happens when the price of the stock opens lower than the recorded low price of the previous day. In comparison to a full gap, a small variation causes a partial gap. So, a partial gap up is seen when the stock price opens above the closing price but is still below the high price on the previous day. Likewise, a partial gap down is when the price is higher than the previous day’s low but still lower than the previous day’s close. The four of these gaps are crucial to gap analysis and its interpretation for stock market trading.
Four Types of Important Gaps
Gaps signal either of these three; the start of a new trend, conclusion of a previous trend, or the continuation of an ongoing trend. Since gap analysis is retrospective, it can therefore work quite reliably for trading. For most day traders, the workday starts way earlier than when the morning bell rings. Vital signals can be observed in the hours leading up to the opening of the market, where traders can use a premarket scanner or other tools to see if stocks are showing strong activity. This might indicate they are fruitful targets for profitable day trades. Gap analysis is a simple process and can be handled with some basic knowledge of charting. It’s critical that you fully understand the four different types of gaps so they can be successfully changed to trading strategies.
- Breakaway gaps- Gaps that occur at the conclusion of a stock’s price pattern. When a stock price breaks out of a trading range that is well-established, that is a breakaway gap and specifically signals either the beginning to heading into a new direction or the start of a new trend.
- Exhaustion gaps are in contrast to breakaway gaps. An exhaustion gap is seen at the end of a pattern of price and is an indication of a last attempt to hit the new low or high in pricing. These gaps can harken the reversal of both bearish as well as bullish bull patterns.
- Common gaps are seen quite frequently in the normal course of trading and are low-impact developments in terms of their effect on price. They are small in size, occur periodically, and are unaccompanied by large volumes. Common gaps have the tendency to fill soon after they form.
- Continuation gaps occur at the very mid-point of a stock’s price pattern and depict a common notion held by a group of sellers or buyers regarding the upward or downward trend of the stock price. As gaps are based on past data and trends, traders that prefer to buy or sell once they have fully confirmed their forecast will find continuation gaps useful.
Imputing Gaps Into Charting
With four differing gap trends, it is crucial that you position your strategy according to your subjective understanding of the gap. Exhaustion gaps signal the end of a trend while continuation gaps indicate that the pattern will continue. Generally, exhaustion and breakaway gaps can be misleading and give ambiguous signals. To factor that in, you must look at trade volumes. By and large, thinning or low volumes are a sign of exhaustion gaps while breakaway gaps are accompanied by high volumes. A lot of times, gaps can really mislead you which is why waiting for gaps to manifest in the market would ensure successful trading. Even if you don’t wait for the full trend to manifest, it is important that you are able to first secure a confirmation.
Those traders often buy and sell with a high chance of success who take time to study fundamental factors at play behind a gap and correctly recognize its type. However, there is always a chance the trade will go bad. There are few steps to ensure you make an educated decision while trading with gaps once you understand how they work.