Gaps in Technical Analysis

Introduction

Gaps are areas on a chart where the price of a stock (or another financial instrument) moves sharply up or down, with little or no trading in between. As a result, the asset’s chart shows a "gap" in the normal price pattern. Traders usually watch for such patterns and try and exploit these gaps for profit. 
Gaps occur because of underlying fundamental or technical factors. For example, if a company’s earnings are much higher than expected, the company’s stock may gap up the next day. This means that the stock price opened higher than it closed the day before, thereby leaving a gap. In the forex market, it is not uncommon for a report to generate so much buzz that it widens the bid and ask spread to a point where a significant gap can be seen. Similarly, a stock breaking a new high in the current session may open higher in the next session, thus gapping up for technical reasons.

 Types of Gaps 
•Breakaway gaps are those that occur at the end of a price pattern and signal the beginning of a new trend.
• Exhaustion gaps occur near the end of a price pattern and signal a final attempt to hit new highs or lows
• Common gaps are those that cannot be placed in a price pattern - they simply represent an area where the price has “gapped”.
• Continuation gaps occur in the middle of a price pattern and signal a rush of buyers or sellers who share a common belief in the underlying stock’s future direction.

Filling of Gaps 
In technical analysis, gaps are said to have been filled when prices move back to the original pre-gap level. These fills are quite common and occur because of the following reasons: 
• Irrational Exuberance: The initial spike may have been overly optimistic or pessimistic, therefore inviting a correction. 
• Technical Resistance: When a price moves up or down sharply, it doesn’t leave behind any support or resistance. 
• Price Pattern: Price patterns are used to classify gaps, one can predict basis the price pattern whether a gap will be filled or not. Exhaustion gaps are typically the most likely to be filled because they signal the end of a price trend, while continuation and breakaway gaps are significantly less likely to be filled, since they are used to confirm the direction of the current trend 
Fading of Gaps

When gaps are filled within the same trading day on which they occur, this is referred to as fading.

Trading Gaps 
There are many ways to take advantage of these gaps. Some traders will buy when fundamental or technical factors favour a gap on the next trading day. For example, they will buy a stock after-hours when a positive earnings report is released, hoping for a gap up on the following trading day. Traders might also buy or sell into highly liquid or illiquid positions at the beginning of a price movement, hoping for a good fill and a continued trend. For example, they may buy a currency when it is gapping up very quickly on low liquidity and there is no significant resistance overhead. Some traders will fade gaps in the opposite direction once a high or low point has been determined (often through other forms of technical analysis). For example, if a stock gaps up on some speculative report, experienced traders may fade the gap by shorting the stock. Lastly, traders might buy when the price level reaches the prior support after the gap has been filled. 

Key things to remember when trading gaps 
• Once a stock has started to fill the gap, it will rarely stop, because there is often no immediate support or resistance.
 • Exhaustion gaps and continuation gaps predict the price moving in two different directions. Hence, correct classification of the gap before entering of trade is crucial.
• Retail investors are the ones who usually exhibit irrational exuberance; however, institutional investors may play along to help their portfolios. Hence, price confirmation is usually required before creating a position. 
• Volume is an important indicator in Gap trading. Usually, high volume should be present in breakaway gaps, while low volume should occur in exhaustion gaps.

Bottom line 
Gaps can be risky due to low liquidity and high volatility, but if properly traded, they offer opportunities for quick profits.

For more Information 
Contact : Rahim : 9892770630
email us at invest@aarpa.in

SOURCE : PLINDIA