Playing the Gap

In volatile markets, traders can benefit from large jumps in asset prices, if they can be turned into
opportunities. Gaps are areas on a chart where the price of a stock (or another financial instrument) moves
sharply up or down, with little or no trading in between. As a result, the asset's chart shows a gap in the
normal price pattern. The enterprising trader can interpret and exploit these gaps for profit. This article will
help you understand how and why gaps occur, and how you can use them to make profitable trades.
KEY TAKEAWAYS
 Gaps are spaces on a chart that emerge when the price of the financial instrument significantly
changes with little or no trading in-between.
 Gaps occur unexpectedly as the perceived value of the investment changes, due to underlying
fundamental or technical factors.
 Gaps are classified as breakaway, exhaustion, common, or continuation, based on when they
occur in a price pattern and what they signal.

Gap Basics
Gaps occur because of underlying fundamental or technical factors. For example, if a
company's earnings are much higher than expected, the company's stock may gap up the next day. This
means the stock price opened higher than it closed the day before, thereby leaving a gap. In the forex
market, it is not uncommon for a report to generate so much buzz that it widens the bid and ask spread to a
point where a significant gap can be seen. Similarly, a stock breaking a new high in the current session may
open higher in the next session, thus gapping up for technical reasons.

The large candlestick identified by the left arrow on this GBP/USD chart is an example of a gap found in the
forex market. This does not look like a regular gap, but the lack of liquidity between the prices makes it so.
Notice how these levels act as strong levels of support and resistance.

We can see in Figure 1 that the price gapped up above some consolidation resistance, retraced and filled
the gap, and finally, resumed its way up before heading back down. We can see there is little support below
the gap, until the prior support (where we buy). A trader could also short the currency on the way down to
this point if he or she were able to identify a top.

 
Gaps are risky—due to low liquidity and high volatility—but if properly traded, they offer opportunities for
quick profits.
What Is a Gap?
A gap is an area discontinuity in a security's chart where its price either rises or falls from the previous day’s
close with no trading occurring in between. Gaps are common when news causes market fundamentals to
change during hours when markets are typically closed, for instance an earnings call after-hours.

KEY TAKEAWAYS
 A gap is a discontinuous space in the price chart of an asset or security, often occurring between
trading hours.
 There four different types of gaps – Common Gaps, Breakaway Gaps, Runaway Gaps, and
Exhaustion Gaps - each with its own signal to traders.
 Gaps are easy to spot, but determining the type of gap is much harder to figure out. 

What Does A Gap Tell You?

Gaps typically occur when a piece of news or an event causes a flood of buyers or sellers into the security. It
results in the price opening significantly higher or lower than the previous day’s closing price. Depending on
the kind of gap, it could indicate either the start of a new trend or a reversal of a previous trend.

The Difference Between Different Types of Gaps

There are some fundamental differences between the different types of gaps: – Common Gaps, Breakaway
Gaps, Runaway Gaps, and Exhaustion Gaps.

Example of a Gap
What Is an Exhaustion Gap?
An exhaustion gap is a technical signal marked by a break lower in prices (usually on a daily chart) that
occurs after a rapid rise in a stock's price over several weeks prior. This signal reflects a significant shift
from buying to selling activity that usually coincides with falling demand for a stock. The implication of the
signal is that an upward trend may be about to end soon.

KEY TAKEAWAYS
 This technical signal marks the potential change from upward trend to downward trend.
 The signal has three main characteristics including increased volume and a downward price break.
 Exhaustion gaps imply that buyers are used up or exhausted and don't have enough orders to
overwhelm the significant number of new sellers that seem to have entered into the market.


The principle behind an exhaustion gap is that the number of likely buyers has diminished and sellers have
aggressively stepped into the market. The buyers may be largely exhausted implying that the upward trend
is likely about to stop as sellers take profits from a previously extended rise in the price of the stock. The
exhaustion gap has three particular features.

1. Several weeks or months of upward trend in the share price of a stock.

2. A sizable gap between the lowest price of the day previous and the highest price of the most recent
trading day (roughly half the range, or better, of an average trading day for that stock).
3. An above average degree of trading volume taking place on the current day.
Notice how the price action shown in this chart is trending higher prior to the exhaustion gap, and the gap
and following price drop appear to break the most recent trend. In the first example noted, the price reaches
a climactic peak and the volume surges higher, culminating in the highest volume on the day following the
downward, exhaustion gap. Buyers had previously been enthusiastically buying shares sending the price
rapidly higher. Whatever was driving these buyers to purchase the stock at these prices was drawing the
attention of many potential investors. Once the price reached its highest level, then it was as if there were
simply no more buyers to push prices higher.