Editors Note: I frequently get asked on Twitter or via my Contact page why a certain stock "gapped up" or "gapped down" and if the investor should react to it. It is important to understand the nature of gaps and Zachary does an excellent job of explaining the basics.
Guest Post by Zachary D Brethauer
Gaps occur because something has significantly changed the forces of supply and demand for a particular security. When price gaps up, sellers are no longer willing to part with shares at the currently traded price or the closing price from the day prior. When price gaps down, buyers are refusing to exchange shares of the currently traded price or closing price from the day prior. Both of these events usually stem from pertinent news about the immediate past or future of the security in question, and since the market is considered a leading indicator, the largest gaps come from changes in the future guidance of that particular security.
Let's take a look at a quick example, XYZ Inc. in its most recent earnings report comes out with a new product that is slated to considerably improve the company's future earnings and possibly create a brand-new market segment. The lucky people who have the shares are now unwilling to sell them at the prior days close and one in extra three dollars to part with their shares. Demand for the shares pick up as buyers, wanting to be a part of the company's burgeoning growth potential, happily pay the extra three dollars for the shares. When the market opens the next day a gap up occurs for exactly 3 dollars. This type of gap may end up being what's called a breakaway gap, where price has lain dormant for some time but this fresh news's barks at torrent of new demand for the shares. There are also three other kinds of gaps that will discuss in the coming section and those are common gaps, runaway gaps, an exhaustion gaps.
Common gaps also referred to as an area gap or trading gap, occur with no real catalyst about the future of the security in question. These types of gaps usually occurred during uneventful times and most commonly when volume for a particular security is low, referred to as being thinly traded. An example of a common gap may be a security that has an upcoming ex-dividend date where volume falls off and inexperienced market participants are willing to pay whatever price is being offered. These types of inefficiency gaps are usually "filled" very quickly, meaning that price will retrace to the close of the day prior to the gap. When this happens it is known as "filling the gap". Sometimes you'll hear traders say that Gaps HAVE to be filled, but this is mainly due to an old methodology of thinking or marketing experience.
Breakaway gaps occur during exciting times in a security's life and are usually accompanied by high volume. For a gap to be considered a breakaway gap, the security's past price data has to of been going sideways for a while, this is also referred to as an area of congestion where price move sideways usually within a defined range continually bouncing off support and resistance. For price to move sideways, key support and resistance lines are usually horizontal with buyers coming in when price touches the support line and sellers dumping shares at the resistance line. Price can remain in this range for weeks, months, and even years, and as time passes the support and resistance lines become even more entrenched making it harder for price to escape. Fresh market enthusiasm, usually accompanied by spike in volume, is necessary for price to finally escape this range and the resultant gap usually occurs because traders accustomed to the range will have to quickly cover their positions to mitigate losses. This is one of the reasons why these gaps can be some of the largest.
Runaway gaps are also caused by an increase in market enthusiasm for a particular security, but have one main difference from breakaway gaps in that they usually occur during a well-defined up or downtrend. A runaway gap to the upside usually represents market participants who waited on the sidelines during the initial trend, sitting on their laurels waiting for a pullback to get in too long positions. But there's only one problem, price steadily continues upward and all the sudden the anxiety of missing the move becomes too much to handle. In a rush to get in, buyers are falling over each other paying whatever price sellers are demanding resulting in a runaway gap to the upside. Runaway Gaps commonly have significantly higher volume on days before and after the gap. Getting into positions after a runaway gap occurs can be difficult due to increase price volatility as market participants with early entry book profits.
Exhaustion gaps are the evil cousin of runaway gaps in that they occur at the end of a long-standing trend and may signal a reversal of the trend. Exhaustion gaps are commonly identified by massive spikes in volume that can be many multiples of the securities average trading volume. Exhaustion gaps are the most profitable gaps to trade because there's so much emotion involved in the last gasps of the trend that people who were waiting on the sidelines for the trend to end, come in guns a blazing securing a premium spot for their stop losses.
I hope that you enjoyed my analysis of "The Big 4" Gaps in trading. If you would like to learn more about technical analysis as well as how to apply it in Day Trading please visit my website where I teach Day Trading Strategies in video webinar format. Here's the best part... It's free! Enjoy
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