- 1998: Volume 7, No. 6 Gaps

A gap is simply a price level where a market does not trade. In a rising market, a gap occurs when prices open at a higher level than the previous day's high and do not trade lower to fill the space. The reverse is true for a falling market. Gaps signal market strength and weakness, respectively.

Types of Gaps

There are four basic types of gaps and they are only distinguished by their placement within the chart pattern. These are called breakaway, continuation, exhaustion and "other." The last category is simply a catch-all for gaps not interpreted as any of the other three.

Breakaway gaps occur at the completion of an organized price pattern and usually signal the start of a significant price move. They are important because they emphasize that there was a breakout and this becomes an even stronger signal when it occurs with higher volume. Heavy volume breakaway gaps are usually important levels of support and resistance over the longer term as well.

Figure 1

When market participants are adjusting their activities in a consolidation pattern such as a rectangle, triangle or head and shoulders, they buy and sell to lock in profits and limit losses within a defined price range. Whether these ranges are constant (rectangle) or tightening (triangle), value in the market remains at accepted levels. At the breakout, market opinion has shifted. A gap signifies that a very large share of market participants have changed their opinions together and is a very powerful indicator.

Once a rally or decline is underway, the market pauses and retraces as participants again position themselves. These sorts of patterns are to expected but sometimes market opinion is so strong that there is no time for normal profit taking and last chances to establish a position (long or short, depending on the market). When the majority of participants think a market will continue its move, the market can simply jump to those new prices immediately and this is known as a continuation gap. Because these types of gaps typically occur at the half way point of a move they are sometimes called measuring gaps. Continuation gaps can occur alone, as a series of gaps or not at all.

The last of the classified types is called an exhaustion gap because it occurs near the end of the move to signal a last push toward new highs or lows. It is sometimes to difficult to identify this type of gap because it appears in a trending market just like a continuation gap. Price action in the days immediately following the gap help the analyst determine which kind of gap it was. Whereas continuation gaps are following by a continuing strong trend, exhaustion gaps are followed by more congested, sideways market action. Such signals as one-day reversals help identify which gap has occurred.

Prices usually trade back to fill the gap and when they do, it is a good sign that the move is over. The gap represents the market "frenzy" where all participants are buying or selling at any price just to be involved. The smart money uses this activity to take profits, leaving only the weak participants left to try to push the market further.

A common reversal pattern seen with exhaustion gaps is called an "island reversal." After a market gaps (exhaustion), it usually trades for a few days in a small range. If the relative numbers of weak participants is high, those last minute buyers or sellers quickly reverse their positions to cause a gap in the opposite direction. The shape of the gap, congestion and reverse gap looks like an island surrounded by water. This sort of pattern usually signals a strong change in trend.

The final category for gaps does not really have a name but has been called "common" or "unclassified" gaps. These types of gaps occur within price patterns or congestion zones and are the least meaningful of all gaps. They generally signify a lack of direction in the market or lack of conviction of the market participants. News and sentiment affect these markets more than others simply because they are less liquid at that time.

While this discussion has focused on daily charts, gap analysis is valid for all time frames such as 5 minute and hourly. As markets trade closer to 24 hours, gaps become less likely. Overnight news has less chance to affect them so intraday analysis may become more prevalent.

Michael N. Kahn is a columnist for Barron's Online based out of Florida. He also writes a free technical newsletter. To subscribe to this service, please visit www.midnighttrader.com. The complete collection of Michael Kahn's "Tips on Technicals" is available in Real World Technical Analysis.