What are Chart Gaps?


Gaps price chart

Technical analysis exists because of two core ideas; the existence of traders who follow chart patterns and use technical analysis tools, and secondly because certain concepts are reflective of investor psychology. The simplest example of investor psychology is where investors set limit sells at round numbers, which causes resistance to show on the chart. This tutorial will look at what chart gaps are, different types of gap and the psychology behind each that allows you to trade the patterns that follow thereafter.

What is a Chart Gap?

First and foremost, to be able to see a chart gap we need to employ the use of a specific type of chart; a candlestick chart. There are other chart types that work, but this tutorial will look at the candlestick version. I'll look at different types of chart in a future tutorial, but for reference it looks like the chart type shown on the right hand side of the image below. Your chart platform should also have it labelled.

Charting Technical Analysis Gaps

The above two graphs show the price movement for Amphion Innovations (LSE:AMP), a small company listed in the UK. The chart on the left hand side is a line chart and shows intra-day movements between June 1st 2015 and June 6th 2015, whereas the right hand graph is the candlestick chart and shows the daily movements for Amphion between mid-April and June 6th 2015.

The important points to note about a candlestick chart for this tutorial are as follows:
- The bulk of the candle is shown as either the white or black bar. The bar is white if the share price on that day was higher at the close than at the open. The bar is black if the share price on that day was lower at the close than at the open. For example, if the share price opens at 5p and closes at 6p then it has risen since the open, and the bar will be white.
- The vertical line extending out of the bar shows the high and low prices for the day. These are known as the upper and lower candle wicks.

If you look on the right hand graph you can see a massive gap between the last two bars; this is a chart gap. A gap is simply where two candles/wicks do not cross and if you think about it, this will occur if there is a big move in a stock when it opens for trading.

The primary reason for this will be some sort of news that leads to the share price being 'gapped up' or 'gapped down' at the open. Indeed, we can clearly see this on the intra-day chart on the left. Right at the open on June 5th 2015, we can see that Amphion dropped from 8.75p to about 6.5p. What was the significant news that drove this? Amphion announced, at 7am on June 5th, that it had completed a placing at 5.25p, which was a severe discount at the time. This was negative news at face value hence the stock was gapped down at 8am when the market opened. We can see that on the line chart.

That sums up what a gap is, but it's fundamental to being able to interpret the investor psychology side. It's an immediate movement of the share price, at the open, that is a significant change from the previous close price. It is almost always caused by significant news that is released before the markets have opened.


Different Types of Chart Gap

For each of these gap types we will look at their typical pattern and then how you could trade the aftermath of these gaps, looking closely at the psychology involved. As before, the absolutely pivotal point to remember for each of these is that the gaps are often based off unexpected news (or a particularly large market-wide move, which is also exogenous and unexpected). This is important when we consider the psychology.

Note that I will refer to the typical move; ultimately this will not be replicated in every case.

The Common Gap: This is a gap that occurs between trading days without major news. The size of the gap rarely exceeds 2% and is often found as part of a general horizontal trading. It has no major importance of psychological read-through so we can leave this type of gap.

The Breakaway Gap

Stock Chart Analysis Breakaway Gap

The breakaway gap is an upward gap that occurs when a stock breaks out of an established consolidation range (also known as a congestion zone). As you can see above with Savills, the consolidation range that was broken out of was between ~815p and 850p. The gap up smashed through the upper end of that range where there was resistance a 850p.

A breakaway gap is a preferred type of breakout given that there must have been strong news to generate the breakout in the first place. Therefore, it is often preferred to general breakouts without a gap. A breakaway gap is further improved if the gap up comes at the conclusion of a bullish chart pattern such as a pennant, flag or wedge. In addition, the higher the volume on the day of the breakout, the better.

So what's the general move thereafter and the psychology behind it? The typical move following a breakaway gap is a continued strong uptrend. This is as a result of investors taking note of the news and buying in over the following weeks and also as a result of traders buying the positive breakout. There is typically not much of a retrace in the days after the gap up.

The Breakdown Gap

Stock Chart Analysis Breakdown Gap

A breakdown gap is the opposite of a breakaway gap. It is a sharp downward gap caused by the release of negative news, whilst the share price is in a consolidation range. You can see this with Afren; the consolidation range was 140p to 150p and the gap down took the share price below 120p. Refer to the breakaway gap's second paragraph for trends that also follow across to the breakdown gap, but in the opposite way.

So what's the general move thereafter and the psychology behind it? The typical move following a breakdown gap is a continued short-to-medium-term downtrend. Similarly, this is because there will be investors who either did not notice or were unable to sell on the initial day of the news, and proceed to in the weeks after. General market sentiment towards the stock is usually weak too, given the bearishness of the news. There is typically not much of an upwards retrace in the days after the gap up, with any bounces sold into.

The Continuation Gap (a.k.a Runaway or Measuring Gap)

Stock Chart Analysis Continuation Gap Example

The continuation gap is different in that it occurs part way through an already established upwards/downwards trend, rather than a consolidation range. When a continuation gap occurs, it signals increasing price strength/weakness in the prevailing direction and is often based off above average volumes. From Tesco's chart above, there are two clear examples of continuation gaps within an overall downward trend. If you have a bullish continuation gap it might be because of an earnings upgrade and an upgrade to an already bullish outlook, and vice versa for a bearish continuation gap.

So what's the general move thereafter and the psychology behind it? The typical move following a continuation gap is for either a consolidation range, or a continuation of the direction of movement before the gap. Therefore, you often have an upward trend form after a bullish continuation gap.

One version of the psychology refers to many investors waiting to buy the stock on a dip, then the positive news comes out, and they ignore waiting for a dip and purchase in. In addition, new investors are attracted to the stock. Again, for the bearish case, potential investors are put off investing with the new negative news and buying pressure is weakened, with selling pressure in the following weeks, strengthened. If there is a consolidation range forming after the gap, it signals a mixture of profit taking balancing out new buying pressure. This usually resolves into a shallow upward trend.

For reference, an example of a bullish continuation gap is shown below.

Greggs continuation gap on chart

The Exhaustion Gap

The exhaustion Gap chart example

An exhaustion gap is a type of continuation gap in that it occurs at the top of a long upward or the bottom of a downward trend. The problem with an exhaustion gap is that it is a reversal signal rather than a signal to buy. Indeed, since it occurs at the top/bottom of a long trend, it is associated with either a rush to buy the stock (euphoria) or a rush to sell the stock (panic). These traits are often directly associated with a reversal being imminent, too.

The problem is, how can we tell if a gap is a upward continuation gap or an upward exhaustion gap? Remember that an upward exhaustion gap is bearish. There are three general methods:
  - Look at the volume; because of the sheer panic/euphoria, the traded volumes tend to be very high.
  - Wait up to a week and examine the price movement in the days thereafter. If the share price falls back by more than 40% of the gapped rise, then there's a very good chance you have an exhaustion gap. 40% is a rule of thumb. You can see this was the case with Blinkx in the chart above; within 4 days the entire gap up had been retraced. Conversely, if the stock exhibits strength in the days after the gap, you are more likely to be looking at a bullish continuation gap.
 - Examine the intra-day movement. If the stock reverses significantly from the open price, then it has a higher chance of being an exhaustion gap.

So what's the general move thereafter and the psychology behind it? The typical move following an exhaustion gap is for a reversal of the price movement. Generally speaking, it is a bearish signal and a signal that you might want to consider cutting/exiting your position. These gaps occur when profit taking kicks in and the stock is no longer fundamentally 'cheap', which leads to a lack of buying pressure after the initial euphoria.

If we have a downward exhaustion gap (a gap that occurs at the end of an downward trend and is bullish), it occurs because the market is is a state of panic and fear, which is often 'overdone'. New investors seeking rock-bottom value enter the stock at overly depressed levels, leading to a recovery from that point.

3 comments:

  1. Thanks El1te, an insightful article as always.

    I often see reference to "filling the gap" (or a market move to do so) - are you able to comment on this phenomenon, what are the drivers behind it and what are the implications for the gap types outlined in your article?

    Keep up the good work, it is much appreciated.

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  2. I plan to cover that topic within a few weeks an had it pencilled in following this piece, so hope that helps. All the best.

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  3. Great article El1te... thanks.... by the way Zak Mir talks about the gap being filled or not as being a strong bearish/bullish sign which I find quite useful to trade with. Speak soon, Tim

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