What are Gaps in Stock Market?

A gap is a capital market term, used to describe discontinuity in a price chart caused by to change in market fundamentals when the market is closed. If the price of an asset significantly rises or falls from the previous day’s closing without any trade taking place in between, a gap occurs. It can occur due to significant market news to sway investors’ sentiment either positively or negatively, like earnings calls after-hours. 

Gaps are common occurrences, but not all of them are of equal significance. Experienced traders know which gaps to take note of and which to ignore. Mainly, gaps in the stock market are categorised into four types. Check them out below. 

What is Gap in Stock Market? 

A gap in the stock market is when the price of a share suddenly jumps up or down from the previous day’s closing price. This jump happens without any trading in between. You can see it clearly on a price chart as an empty space, showing that something big happened, like company news or changes in the economy, while the market was closed. These gaps can give traders clues about where prices might go next. 

Types of Gaps 

Gaps are easy to spot, but determining their importance and interpreting them is what needs knowledge and practice. Here are the four types of gaps that occur in a price line. 

1. Common gaps

Common gaps are also called trading gaps or area gaps. Usually caused by regular market forces and doesn’t require a special event. As the name suggests, these are common occurrences and non-eventful. So, these also get filled up as quickly, meaning the market retraces after a few days or weeks to its original level. 

In a price chart, a common gap appears as a non-linear jump or drop from one point to the next. 

How will you identify a common gap? There is no significant market news that can cause a market rally, and these gaps are usually smaller in size. Common gaps get filled up as fast as they appear. 

2. Breakaway gaps

It occurs when the price tries to break away from the congestion area.  To understand breakaway gaps better, we must understand what congestion area is. Congestion area refers to the price range in the market where the trading is happening for a while. 

The highest point in the congestion is usually called the resistance when approached from below. Similarly, the lowest point, when approached from above, is referred to as the support level.  

A breakaway gap occurs when the market breaks out of the resistance or support barrier. It needs market enthusiasm to cause a switch in trend. That is, either too many buyers for upward movement or sellers for the downtrend swing. 

When a breakaway gap occurs volume of the stock should also pick up, preferably after the gap happens to conform the direction change. A new support level is created where the market breaks out. 

Conversely, the new resistance level is adjusted where the trend breaks downward. Breakaway gaps, unlike common gaps, when appears, usually take a longer time to fill up. 

A good breakaway gap happens when it is associated with the classical price chart. 

3. Runaway gaps

Runaway gaps can happen in both uptrend and downtrend, it usually is a representation of a sudden change in interest or perception about a stock among traders, accompanied by a shift in demand to spike buying or selling. 

Runaway gap, when associated with an uptrend indicates a change in traders’ interest in the stock. Traders, who might have missed the previous uptrend may go for a frenzied buying spree after realizing that a retracement might not happen. This causes the trade volume and price to shoot up suddenly and significantly. 

Similarly, a runaway gap in a downtrend is a representation of excess liquidity in the market.  It may lead to a downward spiral. The seller may panic and sell the stocks, which might cause the stock price to dive lower. 

Traders use a concept of measuring the gap to decide how long the trend will continue. It usually happens in the middle of a trend.

4. Exhaustion gap

As the name suggests, it occurs at the end of a prolonged uptrend or downtrend, indicating a trend change. It is often associated with a rise in price along with an increase in volume. Exhaustion gaps can be mistaken for runaway gaps. To distinguish between the two, traders compare both price and quantity. If both price and volume increase, it is called an exhaustion gap. 

Check out the chart below. Notice that the price rise is accompanied by an increase in volume, which is why it is an exhaustion gap. 

Trading Strategies for Gaps 

Traders use different strategies depending on the type of gap they see on a chart. Some of the most common ones are: 

• Gap and Go: Traders buy or sell in the direction of the gap, expecting the price to continue moving that way. 

• Fade the Gap: This means betting that the gap will “fill”, or the price will return to its previous level. This often works with common gaps. 

• Wait for Confirmation: Instead of jumping in right after the gap, traders wait to see if the price continues in the new direction before placing trades. 

Using the right strategy requires experience and careful attention to trading volume and overall market trends. 

Risks Associated with Gap Trading 

Although gaps can offer trading opportunities, they come with several risks: 

• False Signals: Not every gap leads to a strong price movement. Sometimes the price reverses soon after, catching traders off guard. 

• High Volatility: Gaps often come with sharp price changes, making it hard to set stop-loss levels or manage risk. 

• Unexpected News: Gaps are often caused by news events. If you’re not aware of what caused the gap, trading on it can be risky. 

Traders should always use proper risk management, like setting stop-loss orders, and only trade when they clearly understand the reason behind the gap. 

Conclusion 

To trade efficiently, traders should be able to identify and interpret gaps correctly. Even though they are common in daily trade charts, they aren’t free from limitations. A critical concept that associates with gaps is ‘filling’. 

It is a concept where the market readjusts to the price level, nullifying the sudden change caused by the gap. Failing to identify a gap or reacting to it may cause one to miss an opportunity to exit or enter a market, which means it weighs heavily on profit or loss from a trade. 

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