GAPS, HOW TO DIFFERENTIATE THEM?
What are gaps? Are they all filled? Which ones are important from a classical charting breakout strategy? Here is a nice article on gaps with recent examples. I hope this will be helpful in understanding different types of price gaps.
GAPS
Gap is a price range where no shares change hands. Gap on daily charts form when the lowest price an instrument trades ends up being higher than the highest price of the preceding day. Or when the highest price of one day is lower than the lowest price of the preceding day. For a gap to develop on a weekly basis, it should follow the same dynamics on weekly close and open.
Which gaps are significant? Which gaps are closed, and which remain not filled on price charts? Answers to these questions can be the foundation of gap trading. There is a wrong belief that all gaps will eventually get filled. This is not true.
THE COMMON GAP
This type of gap usually forms in a trading range. A news flow or a short-term sudden change in sentiment can cause such gaps and they are usually filled in following trading days. They are not significant and do not have forecasting value. Common gap or Area gap usually forms in consolidations rather than reversals. As a result this can be the only forecasting value they add to the decision making process. A common gap that forms in a consolidation increases the likelihood of that consolidation becoming a continuation pattern rather than a reversal.
The chart above shows NATIONAL INDUSTRIS GROUP daily scale price chart between November 2023 and October 2024. The stock is listed on the Kuwait Stock Exchange. Price chart formed a possible 7 month-long ascending triangle. Inside the well-defined consolidation we can see several gap openings which were immediately filled. They have limited forecasting value, other than the knowledge that they will get filled somehow. Such information can become the basis of a short-term trading strategy.
BREAKAWAY GAP
Breakaway gap also appears in relation to a consolidation area. Though it forms at the time of the completion of the consolidation pattern as price breaks away from the pattern. A strong breakout will usually take place with a gap opening adding conviction to the breakout. Breakaway gaps can form at the time of a breakout from a continuation pattern or a reversal. False breakouts rarely happen with a gap opening. A breakout with a gap is stronger than a breakout that takes place during the day. As a result one can expect the ensuing move to carry prices much higher than initially forecasted.
While rare occasions can take place, breakaway gaps are not filled especially if they are accompanied by higher volumes following the breakout.
The chart above shows CARVANA CO. daily scale price chart between May 2023 and October 2024. The stock is listed on the New York Stock Exchange. After a strong uptrend between May 2023 and July 2023, the stock entered into a lengthy consolidation. The 6 month-long sideways price action was identified as an H&S continuation chart pattern. Breakout form the pattern’s horizontal neckline took place with a gap opening. The gap was a breakaway gap that was followed by a continuation/runaway gap. While the latter gat filled, breakaway gap was not filled during the pullback in April 2024.
The chart above shows the volume pattern throughout the formation and at the time of the breakout as price formed the breakaway gap. The surge in volume is clearly visible. This increased the likelihood of the breakaway gap.
CONTINUATION OR RUNAWAY GAPS
We have seen that both the common gap and breakaway gaps develop in association with price formations of the area or congestion. Common gap in the consolidation area and breakaway gap as the pattern completes, right above or below the pattern boundary. The runaway gap, on the other hand, as well as exhaustion gap which will be discussed next, are not related to the consolidation. The form during the rapid advance following the breakout from the consolidation.
At the time of the breakout, with the formation of breakaway gap we will see volume picking up. After an initial thrust, price will start moving sideways in a profit taking attempt. The price will resume with a strong momentum once again with a pick up in volume. During this second phase of strong momentum, a wide gap is likely to appear which can be identified as a continuation or runaway gap.
In hindsight it is easy to identify runaway gaps. It is important to recognize them as they appear on price charts. There is no danger in confusing them with common or breakaway gaps. It becomes necessary though not to confuse it with an exhaustion gap. Any gap which shows up in a fast advance or decline after prices moved away from the pattern boundary may be a runaway gap. What will differentiate between a continuation gap and an exhaustion gap is the volume pattern.
The gap that followed the breakaway gap was a continuation or runaway gap. The increase in volume was clearly visible after a calm period. The runaway gap alerted the trader to pick up in momentum and the possibility of the uptrend to extend much higher than current levels.
EXHAUSTION GAPS
The two gaps that are not difficult to differentiate between each other but more difficult to come to a conclusion at the time they appear are Continuation and Exhaustion gaps. The exhaustion gap suggests the completion of the movement and an early reversal. The exhaustion gap appears after an extensive move. It occurs usually at the end of a rapid mark-up or mark-down and is rarely the first gap in such price action. The exhaustion gap is more often than not wider than the continuation gaps.
The chart above shows NASDAQ 100 INDEX between January 2024 and October 2024. The example focuses on Gaps that were formed during the sharp correction in July 2024. After an extended period of uptrend, the index broke down trend line support with the first gap opening. Gap labelled with 1 was a breakaway gap. After a short pullback or a pause in the developing downward move, Gap labelled with 2 formed as the trend accelerated. This was the first continuation/runaway gap. Gap 3 was similar to Gap 2 as it resumed the downtrend towards the strong support area formed by the April 2024 low and the 200-day average. In one last attempt of selling where main capitulation and a surge in volume took place, Gap 4 formed. Gap 4 was the widest between all and can be identified as the exhaustion gap.
ISLAND REVERSAL
An island is a compact area of price congestion separated by gaps from the preceding and following price movements. If price gap into the congestion and then gap out again on the same side, with gaps forming at the same level, we have an important pattern, the island reversal. The island can form in one day and is perfectly fine. The most important requirement for an island reversal is the fact that the two gaps at the either end of the island occur opposite each other, at the same price level. At least some part of each gap must come at the same price level.
An island reversal is composed of an exhaustion gap and a breakaway gap. The exhaustion gap is the final euphoric activity in the uptrend followed by the second gap out of the island. The importance of these two information combined is the fact that it forecasts a sharp reversal in the opposite direction of the existing trend.
The chart above shows the daily scale price action of INTUITIVE SURGICAL between July 2022 and April 2023. The stock is listed on the Nasdaq Stock Exchange. Labelled on the chart are 5 different gap openings. Gap that is labelled 1 was a breakaway gap that reversed the downtrend of Aug-Sep 2022 with a breach of the upper boundary of a downward trend channel. Gap 2 and 3 were clearly the continuation/runaway type which resumed the existing uptrend. As the trend matured, volume declined, showing a divergence between the price and volume. Non confirmation was followed by one last gap (GAP 4) in the uptrend which was identified as an exhaustion gap. After 2 days of price action which formed the island another gap this this one the downside formed out of the island consolidation area. With that we have the island reversal pattern confirmed and a forecast made for further development of a downtrend.
