How to play the market gap ups and gap downs

One of the common terms you must have in markets quite often is a gap up or a gap down. Gaps are the space between the open and the closing prices of two consecutive days and such gaps normally get filled. Hence it is an important indicator to the trader in identifying the trading opportunities on the stock. To be precise, a gap is essentially a change in prices levels between the close and the open of two consecutive days. Here we are referring to two consecutive trading days. Gap analysis is retrospective in nature as it requires confirmation that is only available after the price movement actually manifests itself. For example, there are different types of gaps like common gap, breakaway gap, continuation gap and exhaustion gap, but all these gaps are evident only after the price impact is visible on these stocks.

Identifying gap-ups and gap-downs on the chart

Gap ups and gap downs are with reference to two consecutive day’s price levels. It focuses more on prices and does not look at volumes. Let us look at two such very specific types of gaps. For example, a full gap up occurs when the next day opening price is higher than the high price of the previous day. Check the chart below, where the green arrow depicts the gap up point.

A full gap-down occurs when the opening price of the stock is lower than the previous day’s low price. In the chart below, the full gap up is depicted by the green arrow and the full gap down is depicted by the red arrow.

A slight variation of the full gap is the partial gap. A partial gap-up occurs when the opening price is above the previous day’s close but not above the previous day’s high price. This is in contrast to the full gap up where the next day’s open is above the high price of the previous day too. These four gaps (full gap-up, full gap-down, partial gap-up and partial gap-down) are at the core of gap up and gap down analysis and their interpretation in the context of stock market trading.

Four gaps that are critical inputs for chartists

It is important to grasp the four categories of gaps so that these gap events can be converted into trading strategies.

• First are the breakaway gaps. Breakaway gaps are the gaps that occur at the end of the share’s price pattern. Breakaways indicate a break-up or a break-down and are specifically indicative of a new trend or the beginning of a new direction.
• Second is the exhaustion gap. An exhaustion gap is the opposite of the breakaway gap. Exhaustion gap represents the final leg of a price pattern and is an indicator of a final attempt to reach the new high or lows in pricing. Exhaustion gaps are used to indicate the reversal of bull patterns as well the reversal of bear patterns.
• Thirdly, there is a common gap, which represents your preferred trading area. It represents the area of price gap and actually tells you the square area within which to apply your strategy.
• Lastly, the Continuation gap occurs in the middle of a stock’s price pattern and indicates a common belief of a group of buyers or sellers on where the stock is headed. Since gaps are retrospective, this continuation gap is useful for traders who want to enter only after full confirmation.

Using gaps and imputing them into your charting

Gaps emphasize one of the three; the beginning of a trend, conclusion of a trend or the perpetuation of a trend. Here is how you can actually apply the analysis of gaps to your trading strategy in the stock markets. Remember, gaps are retrospective and therefore work quite reliably.

• Gaps are deep pits or high ceilings which have to be filled. It is an area where there is no support or resistance. Once a stock starts to fill a gap, it will not stop and your strategy needs to be set accordingly.
• We saw four different gap patterns and you need to frame your strategy based on your interpretation of the gap. The continuation gap indicates perpetuation of a trend while the exhaustion gap shows the tiring of a trend.
• Normally, breakaway gaps and exhaustion can be confusing and give mixed signals. The answer is to look at volumes. High volumes accompany a breakaway gap while low or thinning volume occurs in an exhaustion gap.
• Many gaps can be misleading and some of them can be too short lived. Wait for the gap to manifest some degree of confirmation before trading it. It is OK to miss the full trend manifestation but it is important to wait for confirmation.

Gap analysis is quite simple and can be handled with some basic charting knowledge. But the real challenge lies in getting confirmation that it is actually the gap that you believe.

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Disclaimer: The above opinion is that of Sameet Chavan (Chief Analyst – Technical and Derivatives at Angel Broking Ltd). Views expressed are his own.