Gap

What Is Gap?

A "gap" in financial markets refers to a discontinuity in a security's price chart where there is a significant difference between the closing price of one trading period and the opening price of the next, with little or no trading activity in between. This often appears as an empty space on a candlestick chart. Gaps are a key concept in technical analysis, a discipline focused on analyzing historical price and volume data to forecast future price movements. Gaps typically arise from unexpected news or events that dramatically shift market sentiment outside of regular trading hours, leading to an imbalance between buyers and sellers at the prior day's closing price.

History and Origin

The foundational ideas that underpin the study of gaps and other charting patterns can be traced back centuries. Early forms of technical analysis emerged in the 17th century with Dutch traders, such as Joseph de la Vega, who observed and documented market behaviors and price movements.¹²,¹¹ In the 18th century, Japanese rice traders, notably Munehisa Homma, developed sophisticated candlestick charts to analyze rice prices, a method still widely used today.¹⁰,⁹

In the Western world, modern technical analysis, including the systematic study of price discontinuities like gaps, gained prominence in the late 19th and early 20th centuries. Charles Dow, a co-founder of Dow Jones & Company, laid much of the groundwork with his observations on market trends, which evolved into Dow Theory.,⁸ While Dow's work primarily focused on identifying broad market trends, the visual representation of price data on charts naturally highlighted these areas of price jumps or drops, leading to their subsequent classification and analysis by technical analysts. The formal classification of different types of gaps and their implications for future price action developed as charting became more systematized.

Key Takeaways

• A gap is a distinct break in the continuity of a security's price on a chart, where the opening price is significantly different from the previous closing price.
• Gaps often occur due to impactful news or events released when markets are closed, leading to a surge of buying or selling interest at the next open.
• Technical analysts categorize gaps into types such as common gaps, breakaway gaps, continuation gaps (or runaway gaps), and exhaustion gaps, each offering different interpretive signals.
• The "filling of a gap" refers to the price moving back to the level where the gap occurred.
• Interpreting gaps requires an understanding of the context, including surrounding price patterns and trading volume, as misinterpretation can lead to poor trading decisions.

Interpreting the Gap

Interpreting a gap involves understanding its context within the broader trend of a security's price movement and the accompanying volume. Not all gaps hold the same significance; their meaning often depends on where they occur within a price pattern and the market conditions surrounding them.

There are typically four types of gaps:

• Common gap: These gaps often occur in a trading range and are usually filled relatively quickly, sometimes within a few days. They generally do not signal a major change in trend and are associated with normal average trading volume.,
• Breakaway gap: This type of gap occurs at the beginning of a new price trend and breaks above a key resistance level or below a support level, often signaling the start of a significant move. They are typically accompanied by high volume and tend not to be filled quickly.,
• Continuation gap (or Runaway Gap): These gaps appear in the middle of an existing strong trend, indicating a rush of buyers or sellers who share a strong conviction about the security's future direction. They suggest that the current price trend is likely to continue and are usually accompanied by significant volume.,
• Exhaustion gap: Occurring near the end of a prolonged price trend, an exhaustion gap signals a final burst of buying or selling before a reversal. These gaps are often accompanied by high volume initially, but the momentum quickly fades, leading to the gap being filled. They indicate that the preceding trend is likely nearing its conclusion.

Hypothetical Example

Consider a hypothetical stock, "Tech Innovations Inc. (TINV)," which closed at $100 per share on Friday. Over the weekend, the company announces unexpectedly positive clinical trial results for a new drug. When the market opens on Monday, there's a flood of buy orders, leading TINV's stock to open at $110 per share. This creates a $10 "gap up" on the price chart, as no shares traded between $100 and $110.

If this gap were a breakaway gap, it would suggest a strong new bullish trend beginning for TINV. Traders observing this would look for further upward movement, supported by high volume. Conversely, if TINV had been in a prolonged uptrend, and this $10 gap occurred with extremely high initial volume followed by quick selling pressure, it might be interpreted as an exhaustion gap, signaling that the rally might be nearing its end.

Practical Applications

Gaps are frequently observed across various financial markets, including equities, commodities, and foreign exchange. They are particularly prevalent when significant news, such as earnings reports, economic data releases, or geopolitical events, occurs outside of regular trading hours. For example, major U.S. indices like the S&P 500, Nasdaq, and Dow Jones have been observed to gap higher at market open following favorable trade deal announcements, reflecting immediate shifts in market sentiment before trading can occur at previous price levels.⁷

Traders and investors use gap analysis as part of their broader technical analysis strategy to identify potential entry and exit points for trades. For instance, a breakaway gap through a significant support and resistance level might signal a strong new trend, prompting traders to initiate positions in the direction of the gap. Conversely, an exhaustion gap can alert traders to potential trend reversals, suggesting it might be an opportune time to close existing positions or consider opposing trades. The concept of "gap filling," where the price eventually returns to the level of the gap, is also a common observation and can inform trading strategies.

Limitations and Criticisms

While gaps are a widely used concept in technical analysis, their effectiveness and predictive power face criticism, particularly from proponents of the Efficient Market Hypothesis (EMH). The EMH posits that all available information is already reflected in current asset prices, making it impossible to consistently achieve abnormal returns by analyzing past price movements, including gaps.,⁶ Critics argue that any success derived from gap trading might be attributable to luck or a self-fulfilling prophecy, where many traders acting on the same signal inadvertently cause the predicted outcome.,⁵

Furthermore, the interpretation of a gap can be subjective. Identifying the specific type of gap—whether it's a common gap, breakaway gap, continuation gap, or exhaustion gap—can be challenging and prone to misinterpretation. Misinterpreting a gap can lead to incorrect trading decisions and potential losses. The dynamic nature of financial markets and unforeseen events can also render historical gap patterns unreliable for predicting future movements. Issues in market microstructure, such as information asymmetry and fragmented liquidity, can also contribute to gap formation and affect how prices are formed, adding complexity to their analysis.

##⁴ Gap vs. Market Microstructure

While a "gap" refers to a specific visual discontinuity on a price chart, market microstructure is a broader field of financial economics concerned with the intricate details of how exchange occurs in markets. Market microstructure studies the processes and outcomes of trading under explicit rules, examining how factors like order types, market participants, liquidity, and information asymmetry influence price formation, transaction costs, and trading behavior.,

A ³gap can be a result of market microstructure dynamics, particularly when there is a significant imbalance between supply and demand that cannot be absorbed by existing orders during non-trading hours. For instance, an unexpected news announcement can lead to a surge of buy or sell orders that outstrip the available liquidity at the previous closing price, causing the next trading period to open much higher or lower, thereby creating a gap. While gaps are a tangible chart pattern used by technical analysts for trading signals, market microstructure provides the theoretical framework to understand the underlying mechanisms that lead to such price discontinuities and how they impact market efficiency and stability.,

#²#¹ FAQs

What causes a gap in stock prices?

A gap in stock prices is primarily caused by significant news or events that occur when the market is closed. This news can lead to a strong shift in investor demand or supply, causing the opening price to be notably higher or lower than the previous day's closing price. Common causes include earnings reports, major economic data releases, or company-specific announcements.

Do all gaps get filled?

No, not all gaps get filled. A "filled gap" means the price has returned to the level where the gap originally occurred. While common gaps tend to be filled relatively quickly, other types like breakaway gaps or continuation gaps, which signal stronger trends, may not be filled for a long time, if ever.

How can traders use gaps in their strategy?

Traders often use gaps to identify potential trading opportunities based on the type of gap. For example, a breakaway gap might signal the start of a new trend and an entry point, while an exhaustion gap could indicate an impending reversal and a signal to exit or take profits. They also look at volume accompanying the gap for confirmation of the signal.

Is gap analysis a reliable trading strategy?

The reliability of gap analysis, like other aspects of technical analysis, is a subject of debate. While many traders find it useful for identifying short-term opportunities, academic research often presents mixed results regarding its consistent predictive power. It is generally recommended to use gap analysis in conjunction with other analytical tools and methods for more robust decision-making.