One of the common terms you must have in markets quite often is a gap up and gap down. Gaps are the space between the open and the closing prices of two consecutive days and such gaps normally get filled. Hence it is an important indicator to the trader in identifying the trading opportunities on the stock. To be precise, a gap is essentially a change in prices levels between the close and the open of two consecutive days. Here we are referring to two consecutive trading days. Gap analysis is retrospective in nature as it 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 evident only after the price impact is visible on these stocks.
Before diving into the gap and gap down strategies, it’s important to understand what is gap up opening.
Gap Up Opening
When the next day’s opening price is higher than the previous day’s close, this is known as a gap up opening. This usually indicates that the market has opened with positive sentiments.
There are two types of Gap Up openings:
* Full Gap Up Opening
When the next day’s opening price is higher than the previous day’s high price, this is known as a Full gap up opening.
* Partly Gap Up Opening
When the opening price is higher than the previous day’s closing but not higher than the previous day’s high price, this is known as a partial gap-up.
After understanding Gap Up Opening let’s understand Gap Down Opening.
Gap Down Opening
When the stock’s opening price is lower than the previous day’s closing price, this is known as a gap-down. This usually indicates that the market has opened with negative sentiments.
There are two types of Gap Down Openings:
* Full Gap Down Opening
When the next day’s opening price is lower than the previous day’s lowest price, this is known as a Full Gap-Down opening.
* Partly Gap Down Opening
When the opening price is lower than the previous day’s closing but not lower than the previous day’s lowest price, this is known as a Partial Gap-Down.
Gap up and gap down analyses, as well as their interpretation and application to real stock market trading, are all based on these four gaps.
Types of Gaps
In fact, there are four different types of gaps that are significant from an analytical perspective. It is important to recognize these four types in order to effectively transform gap situations into approaches.
* Breakaway Gaps
The gaps that appear at the conclusion of a stock’s price trend are known as breakaway gaps. Breakaway can denote either a break-up or a breakdown. In either case, they signal the start of a new trend or a new direction.
* Exhaustion Gaps
When compared to the breakaway gap, the exhaustion gap is on the other extreme of the spectrum. The exhaustion gap is the last leg of a price pattern, and it indicates a last-ditch attempt to attain new highs or lows in pricing. This is used to show pattern reversals.
* Common Gaps
The extent of the price gap is represented by the common gap, which informs you the square area within which you may implement your plan.
* Continuation Gap
Finally, there’s the Continuation Gap, which appears in the midst of a company’s price pattern and shows a group of buyers or sellers agreeing on where the stock is going. This might indicate the continuation of an uptrend or the continuation of a decline.
Identifying gap up and gap down on the chart
Gap up and gap down are with reference to two consecutive day’s price levels. It focuses more on prices and does not look at volumes. Let us look at two such very specific types of gaps. For example, 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.
A slight variation of the full gap is the partial gap. 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. This is in contrast to the full gap up where the next day’s open is above the high price of the previous day too. These four gaps (full gap-up, full gap-down, partial gap-up and partial gap-down) are at the core of gap up and gap down analysis and their interpretation in the context of stock market trading.
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!