Gap Up, Gap Down: How to Leverage Gaps in Technical Analysis for Optimal Trading Results
The traditional way of seeing a discontinuity in a chart is called a gap, where we see a significant gap between the closing price of one period and the opening price of the next period. Gaps can occur in any time frame, but they are most commonly observed on daily charts.
Gaps can be caused by various factors, suchs as news announcements, market rumors, or changes in market sentiment. One example is earning calls.
Gap as a Leverage
Gaps can tell you several things (and sometimes can mislead you).
They typically appear when something such as news or events causes an influx of buying and selling pressure, causing the price to open significantly higher or lower than the previous day's closing price. This signal can indicate that it may be starting a new trend or reversing a previous trend.
The Four Gap Horses.
There are four types of gaps: Common Gaps, Breakaway Gaps, Runaway Gaps, and Exhaustion Gaps.
They have fundamental differences that deserve to be explained:
- Common Gaps occur within a trading range and there is no major event that precedes this type of gap, they can be pretty insignificant. They are usually filled within hours or a couple of days, and may be known as area or trading gaps and usually coincide with typical market liquidity levels.
- Breakaway Gaps occur at the beginning of a new trend and signal a significant change in market sentiment. They are usually seen above a support or resistance area. A breakaway gap could also arise from a different chart pattern, such as a triangle, wedge, cup and handle, rounded bottom or top, or head and shoulders formation.
- Runaway Gaps occur during the middle of an established trend and signal a continuation of a trend. They are typically seen when the price skips over consecutive levels, typically due to strong investor demand. In other words, no trading happened between the price level where the runaway gap started and where it finished.
- Exhaustion Gaps refer to a gap that occurs at the end of a trend and signals the end of that trend. It is usually followed by a sharp reversal in price, which reflects a significant shift from buying to selling movements, sending a message that the demand is falling. It´s a good idea to take profit or close out positions when exhaustion gaps occur.
Gaps can also be used to identify potential support and resistance levels. A gap that is not filled is considered a support or resistance level. If the price of an asset falls below the low of the gap, it is considered a resistance level. If the price of an asset rises above the high of the gap, it is considered a support level.
What else can they do?
In addition to the commonly known information about gaps in technical analysis, it’s also worth noting that gaps can be used to identify Bullish and Bearish Island Reversal Patterns.
The Bullish Island Reversal pattern is a pattern that forms when a stock gaps down, trades lower, and then gaps up again. This pattern is considered bullish because the gap down is followed by a gap up, indicating that the bears have been trapped and the bulls are taking control.
The Bearish Island Reversal pattern is the opposite, it forms when a stock gaps up, trades higher, and then gaps down again, indicating that the bulls have been trapped and the bears are taking control.
Limitations
As with other indicators in technical analysis, gaps can be misinterpreted by the investor and could lead to a mistake causing one to miss an opportunity to buy or sell, making damage to the profit, or even adding a loss, so the recommendation is to always combine indicators to help you make the best possible decision.
This article belongs to the Technical Analysis series.
Previous articles of the series:
- Crypto & TA: the start of a new series
- Technical Analysis: a look into charts
- Unlocking the Secrets of the Stock Market: Understanding the Power of Dow Theory
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