Decoding stock market gaps: A comprehensive guide

Explore the dynamics of stock price gaps – a window into market sentiment and a trader's toolkit for strategic decision-making.

When financial markets open on a new day, there can be a disparity between the closing price of the previous day and the opening price of the current day, commonly referred to as a "gap." These gaps, visible on price charts, signify periods during which no trading activity occurred within specific price ranges. Traders leverage these gaps for developing strategies, conducting trades, and analysing market conditions to enhance their profitability.

In technical terms, there are two main categories of price gaps: up gaps and down gaps. An up gap materializes when the lowest price aftermarket closure is higher than the highest price from the preceding trading day. Typically interpreted as bullish signals in technical analysis, up gaps indicate positive market sentiment. On the other hand, a down gap occurs when the highest price aftermarket closure is lower than the lowest price from the previous trading day. Down gaps are generally perceived as bearish indications, signalling negative market sentiment.

Gaps in the stock market occur when there is a surge in demand or supply for a stock, especially during market closures. For example, if a company unexpectedly performs exceptionally well and releases positive news after the market closes, there is a rush of buyers wanting to purchase the company's stock overnight. This creates an imbalance as the number of buyers exceeds the number of sellers.

As a result, when the stock market reopens, the stock's price experiences an upward movement due to the high demand. If the stock price remains higher than the previous day's highest price, it leads to the formation of an up gap. Such gaps often signify significant changes in investor sentiment or the financial health of the company, influencing its stock price.

Gaps are divided into 4 categories:

• Common Gaps
• Breakaway Gaps
• Runaway Gaps
• Exhaustion Gaps

Common Gaps

These are uninteresting gaps known as trade gaps. This could be because the stock is going ex-dividend at a time when trade activity is low. These types of gaps are easily filled when price movement retraces to the same level it was at; this is referred to as closing the gap. 

The chart below depicts a perfect common gap that opened down after the dividend with normal volume and was later filled with typical price activity.

Common gap is a gap in the price of a stock that usually happens when the stock is trading in a narrow range or a congested area. It shows that there was not much excitement or interest in the stock at that time. These gaps often occur when there is very little trading activity, meaning not many people are buying or selling the stock. While it is good to know about these gaps, they usually don't provide good opportunities for trading.

Breakaway Gaps

A breakaway gap is like a thrilling event for the price action where it breaks the narrow range of trading with full thrust in which the price was stuck before. To cause a breakaway gap, it is necessary to have many buyers for the up-side gap or sellers for the down-side gap. When a breakaway gap occurs, you'll notice a significant increase in trading volume because people who were on the wrong side of the breakout need to adjust their positions. It's important that this surge in volume happens after the gap appears because it suggests the new market direction is more likely to continue. The level where the breakout occurred now becomes the new support or resistance. Don’t assume the gap will be filled soon, in this case, it may take a long to close the gap.

In the above chart, breakaway gap each and every thing about the gap is shown as mentioned earlier.

Price gaps that occur alongside well-defined chart patterns, like an ascending triangle with a strong breakout gap to the upside, often provide more reliable trading opportunities compared to gaps that happen without such clear patterns.

Runaway Gaps

Runaway gaps are gaps in a stock's price chart that occur due to sudden and strong interest from traders. When there's a runaway gap upwards, it means that traders who missed the initial uptrend suddenly start buying the stock, causing its price to jump above the previous day's closing price. This type of gap often reflects a sense of urgency among traders.

Runaway gaps can also happen during downtrends when traders are selling the stock, and there are few buyers, leading to a gap down in the price. These gaps can sometimes give us clues about the duration of a trend. In rare cases, the futures market may experience runaway gaps due to trading limits set by exchanges, which can be both good and bad for traders.

Below chart shows the example of Runaway Gap.

Exhaustion Gaps

Exhaustion gaps are like warning signs that show up when a strong trend in the stock market is about to end. They stand out because they have a big gap between the previous day's closing price and the new day's opening price, and they come with a lot of trading activity. When these gaps happen after a long downward trend, it can be a sign of panic among investors, leading to a rush to sell their holdings.

In contrast, during an upward trend, people get overly excited and buy a lot, causing the prices to jump with high trading volumes. However, this enthusiasm doesn't last, and profit-taking kicks in. As a result, the trend reverses, and prices drop, marking a significant change in market direction.

Above chart shows the example of exhaustion gap.