Finally, the last chart patterns we will learn in this section are ‘Gaps.’
What are Gaps?
A gap is formed when the closing price of the previous days and the opening price of the next day have different price levels.
This is formed mainly due to any news in that specific stock, after the trading session.
For example, if the company's earnings are higher than expected, then the stock will gap up the next day.
Why Does a Gap Occur?
A gap usually occurs when there is low liquidity in the market. There are not enough buyers or sellers to trade that stock.
It may also occur when there is a high volume in that stock.
Important events like earnings releases and company-related news that impact the market sentiment after the stock closes lead to gaps in the stock prices when the stock opens the next day.
4 Types of Price Gaps:
Gaps can be mainly classified into 4 groups:
1. Common Gaps:
Common Gaps are also sometimes referred to as a trading gap or an area gap.
This gap occurs in nervous markets and is generally closed within a few days. They can be caused by a stock going ex-dividend when the volume is low. A common gap appears in a trading range and reinforces the apparent lack of interest in the stock at that time. Knowing about these types of gaps is good, but it’s usually doubtful that they will produce trading opportunities.
2. Breakaway Gaps:
The breakaway gap usually does not get filled initially. A breakaway gap occurs when the price of the stock gaps over a support or resistance level. It is like a breakout pattern, but here the actual breakout happens in the form of a gap.This kind of gap signals strong momentum and price keeps on trending after a breakaway gap. Furthermore, the larger the breakaway gap, the stronger the next candle after the gap, and the stronger the prevailing trend will be.
3. Runaway /Continuation Gaps:
Runaway gaps are also referred to as measuring gaps. Runaway gaps in an uptrend represent traders who did not get in during the beginning of the uptrend and while waiting for a retracement in price, they decided it was not going to happen. There is increased buying interest all of a sudden. This type of runaway gap represents an almost panic state in traders. Runaway gaps can also be caused by important news events which may cause new interest in the stock. In a downtrend, runaway represents an increase in the liquidation of the stock by the buyers who are standing on the sidelines.
4. Exhaustion Gaps:
Exhaustion gaps usually get filled and the best way to trade an exhaustion gap is not to speculate but use the information to time exits and entries around the pattern. An exhaustion gap usually occurs at the end of a trend or at an important support and resistance level. The first gap in the direction of the trend can look like a runaway gap but the following candle is usually after a Doji pattern showing the indecision or rejection of a price level.
How can gaps be traded?
Traders can build a trading strategy based on the type of gaps formed.
As a rule of thumb, below are some points traders need to consider when trading gap:
- Common gaps usually should be traded in the opposite direction, as the market fills the gap after they occur.
- Continuation gaps signal a strong trend, and traders can enter in the direction of the trend after a continuation gap occurs.
- Exhaustion gaps signal trend reversals and traders should look to enter the opposite trend after they spot this gap.
With the help of the above thumb rules, both the day traders and positional traders can analyze the gaps in the charts and trade accordingly.
So, we have learned the different types of chart patterns, how they are formed, how to identify them and most importantly, what do they indicate. Identifying chart patterns can be useful to many traders to define their targets and stop-loss. But that's not it; to become a successful trader, there is a lot more to learn about technical analysis and trading techniques. So, we have designed many other modules like this on our ELM School that will help you to achieve greater knowledge on the topic of technical analysis and more on overall financial markets.