The Three Types Of Gaps And How To Trade Them

A gap occurs in a price chart when a trade takes place outside of a previous day’s range. Gaps are usually related to news events, but that doesn’t mean they lack genuine value.  Gaps give clues as to the location of the trend, and will many times be reliable predictors of the immediate expected movement.

To be clear, this article is not about trading intra-day opening gap reversals, but rather in recognizing how gaps factor into overall market structure.

Breakaway Gaps

Gaps are a form of impulse.  An impulse, as per Ralph Elliott (yes, that Ralph Elliott) is an increase in momentum. Very often, a congestion pattern will be broken via a breakaway gap, as the markets energy explodes above the set range. This will often time be a surprise if you are not paying attention to the stock that it happens to.  Since momentum precedes price, these gaps can give clues to the start of a trend, and deserve to be watched for any pause afterwards for a place to get on board a fresh trend.

Breakaway gaps are accompanied by a kick off spike in volume as the move gets started. Contrary to popular folklore, not all gaps are filled, so you may be waiting a while to get on board a move if you wait for one.

In the chart below, although it’s split adjusted, you can see the breakaway gap on QCOM that led to one of biggest moves in the shortest amount of time during the tech bubble.

A stock chart of QCOM

 All charts courtesy of Tradestation

 

Continuation Gaps

Continuation gaps occur during a trending move.  As an analogy, they keep the fire burning by providing fuel in the form of momentum.  Very often continuation patterns will be the half-way point of a trending move, and bring new market participants in that are looking to get on board the trend. Continuation gaps are prone to blow backs, so there may or may not be a gap fill before continuation in the primary trend;s direction.  A conservative method to trading continuation gaps is to wait for a pullback, and set your entry based on that.  If the gap doesn’t retrace, you can always look for another entry, but buying after the gap day is buying retail, and what we want to avoid when we can help it.

Stock Chart of INTC Continuation Gap

Exhaustion Gaps

One of the underlying principles of price action is that trends end in a climax. Often times, this climax will come in the form of an exhaustion gap, which will suck in the late to the party buyers or sellers of a move, leaving them wondering what happened. Good clues to watch for when determining if there could be an exhaustion gap include volume and how far along the trend is. If volume spikes nicely above the 50 day average as well as multiple weeks or month’s peaks, that’s a good sign of exhaustion.  Keep in mind that in an uptrend, a sharp increase in volume is not a requirement, and for either direction it’s not a certainty.  It’s just a good clue.

Second, if the move has been going on for a while, and interest has picked up, that’s a good time to watch for one last burst of emotional exuberance to finish things off.

Exhaustion gaps are usually filled quickly, as those that get trapped are ducking for cover, helping fuel the reversal off of the pattern. While some exhaustion gaps may lead to a little more movement in the direction of the gap, the momentum has usually been drained, which results in a decrease in momentum , only to see the speed pick up when the reversal kicks in.  Look to take advantage of this after the gap gets filled.

Stock chart of Bidu showing an exhaution gap

 

As you see, the three types of gaps all come with different dynamics regarding how to trade them with the least amount of grief.  While nothing follows an exact road map, these are good starting points to build your strategies and tactics from.

 

 

 

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