A gap is essentially a change in prices levels between the close and the open of two consecutive days. Gap analysis requires confirmation that is only available after the price movement actually manifests itself. For example, there are different types of gaps like common gap, breakaway gap, continuation gap and exhaustion gap, but all these gaps are fully clear from a decision point of view only after the price impact is visible on these stocks.
Before getting into gap and gap down strategy, let us first understand why do stocks gap or gap down. Let us also understand about partial gaps and full gaps and then look at how to trade gaps successfully.
Understanding gap-ups and gap-downs
Gaps and gap downs are always with reference to two consecutive day’s price levels. Very important from a decision point of view are full gap ups and full gap downs.
A full gap up occurs when the next day opening price is higher than the high price of the previous day. Check the chart below, where the green arrow depicts the gap up point.
A full gap-down occurs when the opening price of the stock is lower than the previous day’s low price. In the chart below, the full gap up is depicted by the green arrow and the full gap down is depicted by the red arrow.
Similarly, a partial gap-up occurs when the opening price is above the previous day’s close but not above the previous day’s high price. On the gap-down front, it is when today’s price is below the closing price of yesterday but not below the low of yesterday. These four gaps are at the core of gap up and gap down analysis, their interpretation and their application to actual stock market trading.
Breakaway gaps and Exhaustion gaps
Actually, there are 4 types of gaps that are critical from an analytical point of view. It is essential to understand these four categories so that the gap events can actually be converted into strategies.
Breakaway gaps are the gaps that occur at the end of the share’s price pattern. Break away either indicate a break-up or a break-down. Either ways, they indicate a new trend or the beginning of a new direction.
Exhaustion gap represents the opposite end of the spectrum compared to the breakaway gap. Exhaustion gap represents the final leg of a price pattern and is an indicator of a final attempt to reach the new high or lows in pricing. This is used to indicate reversals of patterns.
Common gap represents the area of price gap and actually tells you the square area within which you can actually apply your strategy.
Lastly, there is the Continuation gap which occurs in the middle of a stock’s price pattern and indicates a common belief of a group of buyers or sellers on where the stock is headed. This could be either an affirmation of an uptrend or an affirmation of a downtrend.
Apply Gaps practically in the Indian context
Gaps are a critical component of technical analysis as they either emphasize the beginning of a trend, conclusion of a trend or the perpetuation of a trend. Either ways, this is an important input for your trading decision. There are 4 basic approaches that you must focus on when it comes to applying gaps from a strategy point of view.
Gaps are normally deep pits or high ceilings and these gaps have to be filled. Gap indicates an area where there is no support or resistance. Once a stock starts to fill a gap, it will not stop, and you need to calibrate your strategy accordingly.
Each gap has its own interpretation and hence has its own strategy attached to it. For example, the continuation gap shows perpetuation of a trend while the exhaustion gap shows the fag end of a trend.
How do you differentiate between a breakaway gap and an exhaustion gap? Both tend to look quite similar at times. The answer is to look at volumes. Normally, high volume occurs in a breakaway gap, and low volume occurs in an exhaustion gap.
Don’t jump into any gap the moment you spot the trend. Many gaps can be misleading and some of them can be too ephemeral. Wait for the gap to manifest some degree of confirmation before trading it.
Gap analysis is actually quite simple or, at least, not as complex as it is made out to be. Trading short term is all about making small profits consistently. That is exactly what these gaps can help you do!