Price gaps occur where no trades executed between two prior prices. The result is a visibly empty vertical gap between two consecutive price bars. Buyers and sellers could not agree on prices, resulting in zero transactions. The distance between the last bar and the new bar is the distance traders had to move to find an opposing party to their proposed transactions. If prices gap upwards, demand had to rise their offering prices to find sellers. An upward gap displays strength in the underlying asset that is worthy of investigation. If prices gap downwards, supply had to lower their offering prices to find buyers. These gaps show a poor or deteriorating marketplace. Gaps between bars should never be measured until the bar after the gap closes. Bars which open after a gap can retrace the gap to fill the empty space.
Gaps are caused by changing circumstances that drastically affect price. Gaps are frequent after the release of economic or earnings reports which are highly relevant to the underlying security’s fundamentals. They occur most often when the markets are closed and news or events arise that change future expectations.
Gaps can be seen in bars and candle charts over any time period (with the exception of range bars). Range bars will fill the empty space with multiple bars, each one the distance of the specified range. Time, Tick, and volume bars will reveal gaps between bars. Gaps in time bars have a special note that should be observed. The longer the time frame featuring the gap, the greater the significance of the gap. If you see a monthly gap, it has more significance than a weekly gap. Weekly gaps have more significance than daily gaps, which mean more than intraday gaps.
In many cases, the space after an upward gap will become a support zone. The space after a downward gap may become a resistance zone. If the gap is filled, the resistance or support zone is broken, and its significance will be reduced.
The strength of the gap can also be inferred from volume. The higher the amount of volume shown during a gap, the stronger the gap and the less chance it will be filled in the future. If volume is low, there is a stronger chance the gap space will be retraced in the future. If the volume is high, the price will normally stay on the other side of the gap for a period of time. High volume on and immediately follow a gap will lead to a continued trend or sideways movement that does not fill the gap.
There are four types of gap seen in technical analysis. These gaps vary in importance, and their likelihood of being filled varies accordingly. They consist of Common, Breakaway, Runaway, and Exhaustion Gaps. A runaway followed by an exhaustion gap may form an island reversal or island reversal grouping.
Common gaps are the simplest form of gaps. They are also the most meaningless. It’s fairly normal to see no major news events associated with them. They seem to happen without reason or cause. As a result, there’s no real reason they cannot or will not be filled in the future, and fillings are a regular occurrence.
Common gaps typically occur on low volume. They are also based on the amount of liquidity in the security traded. Lightly traded securities have low liquidity and typically have more common gaps.
The primary difference between a breakaway gap and a common gap is the reasoning behind it. A common gap has little to no reasoning behind it. A breakaway gap always has news or events which drive the price movement.
Since there is an obvious underlying fundamental reason for price to begin moving in the direction of a new trend, investors enter the position on that side of the trend’s movement. Their actions increase volume in either positive or negative price direction. These gaps always occur on higher volume.
Breakaway gaps are the first sign of a new trend. Breakaway patterns typically occur as part of a breakout or a reversal pattern. They often break a resistance level upward or a support level downwards. The new trend moves in the same direction as the breakaway gap. Since the trend generally keeps moving, these gaps are rarely filled in the short or mid-term. The fundamental change that occurs also strengthens the gaps psychological consideration as a support or resistance point, reducing the likelihood it will be filled.
If breakaway gaps begin a trend, runaway gaps continue trends. They when a price has been continuing in a set trend but suddenly leaps further in the same trend direction, leaving a visible blank space between the close and opening of two bars. They have a tendency to occur close halfway in a trend, as a result they have the nickname measuring gaps. These gaps are created by fundamental changes to the underlying security that confirm the existing trend and accelerate it. These gaps usually occur as reactions to news, events, or fundamental reports.
A runaway gap in an uptrend is a sign of continuing strength in the underlying asset’s market. After an upward gap, the empty space usually becomes a support zone for future prices. A runaway gap in a downtrend is a sign of weakening and reduced desire to own the security, and the empty space usually becomes a resistance area.
The support and resistance zone are important, since runaway gaps are usually followed by a temporary pullback. This pullback occurs when traders decide to take profit on a trade, moving the price up if the gap was downwards, or moving price down if the gap was up. The price halts at the gap, or close to it, before resuming the trend’s direction. Many traders enter positions or increase position sizes in the trend direction on the pullback, since entering the trend becomes slightly cheaper at that point.
If breakaway gaps begin a trend, and runaway gaps continue trends, then exhaustion gaps end trends. These are the final gaps that occur in a trend before they fizzle out. After exhaustion gaps a reversal will typically occur, usually after multiple bars or a sidewinding trend. Sometimes the reversal begins after only one bar. This reversal is often started by a breakaway gap.
Exhaustion Gaps almost universally occur at low volume. The lower volume combined with a gap indicates that only a few traders created the gap itself, and they probably will not have the steam to continue the trend. If no one is willing to continue the trend in the future, a reversal becomes substantially more likely to happen. Be suspicious of gaps created on lower volume, especially if the gap is moving upwards. Uptrends require continuous buying to continue, and an upward gap with little or no volume will fizzle out shortly in the future.
The island reversal combines the exhaustion gap with the breakaway gap. In between it has either a single bar or a small trading range. This technically is a form of a reversal pattern. The exhaustion gap moves in the same direction as the existing trend. A single bar or a trading range will appear immediately afterwards. These bars form the actual “Island Reversal”. A breakaway gap will occur moving in the opposite direction, beginning the new trend and completing the actual reversal.
These patterns occur when new positions are created late in a trend, typically on an exhaustion gap. There will not be enough steam to continue the trend, and fresh entries will slowly realize they are about to lose money. The combination of old investors taking profits on trends plus new investors panicking and selling out results in the breakaway gap creating the new trend with substantial volume. An Island gap that occurs in a downtrend gives a heavy buy signal, but an island gap in an uptrend gives a heavy sell signal.
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