Mind the Gap

Apurva Sheth
Finally, the Fed announced its much-waited policy, relieving anxiety across global financial markets. Fed chair Janet Yellen obliged with the majority view and held interest rates.

In all this uncertainty and guesswork, one thing was certain here in India irrespective of the Fed's decision: markets would open with a gap up or down. Whether it would be a gap up or a gap down was widely debated ahead of the event.

A friend of mine heard the discussions and wanted to learn more about gaps. Last week when we met, he was eager to learn about gaps in detail - why they occur, what they mean ­­- so I pulled up a piece of paper and started explaining it to him.

A gap in a technical chart is an empty space between one trading period and the previous trading period. A gap can form between the daily candlesticks of two days on the daily price chart of any security.

Gaps can form in two ways - up or down.

An upward gap forms when the low of the second day is higher than the high of first day. For example, the high of day one is 100 and the low of day two is 104.

A downward gap forms when the high of the second day is lower than the low of the first day. For example, the low of day one is 50 and the high of day two is 47.

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The vacuum or void between 100-104 and 50-47 is the gap.

Gaps usually occur when an event takes place that can have material impact on the security. So in this case, the Fed policy meeting was a make or break event for the markets.

'Do gaps have any implications on where they occur in a trend?' my friend asked.

'Yes, definitely,' I replied.

I showed him this chart for a quick explanation.

Type of Gaps

Four types of gaps can occur on a price chart.

First is the common gap. As its name suggests, this gap occurs frequently - and therefore doesn't have any forecasting significance. These gaps usually form when the price is trading sideways. That is, when a stock is trapped in a range between support and resistance, the gaps formed in these ranges will mostly be common gaps. 

Second is the breakaway gap. This gap occurs when prices break out of a congestion zone. A congestion zone is nothing but a bottom or top reversal pattern. When price breaks out of such patterns with a gap, it indicates that the change in trend and sentiment is strong and powerful. If heavy volumes support the breakout, then the importance of the gap increases.

A runway gap, or measuring gap, is normally formed in the middle of an uptrend or downtrend. Runaway gaps may occur when the price breaks out of a continuation pattern. They may also occur when price is moving in a sharp trend up or down. There can be more than one runaway gap in any trend. Since a runaway gap forms in the middle of a trend, it gives a rough indication of how much further the security can move from these levels.

Finally, an exhaustion gap occurs at the end of a move. An exhaustion gap indicates a slight or severe panic situation. It can either be a panic top or bottom. But in both cases, its formation indicates that anyone and everyone who could have participated in the ongoing trend is already in it. So there is very little demand left in case of an uptrend or supply left in case of a downtrend. The significance of an exhaustion gap increases when it is coupled with heavy volumes.

As soon as I finished explaining the four types of gaps to my friend, he asked me whether it is necessary that trends begin and end with these gaps always.

I knew that was coming.

Well, you might have the same question, so let me tell you that it is not at all necessary that trends begin and end with these gaps. In fact, it is not at all necessary that you will find all three gaps in a trend. You may see only one or two of the three important gaps (breakaway, runaway, and exhaustion) in a trend. But that doesn't reduce the importance of gap that was formed.

Let's check some of the gaps that have recently formed in Nifty.

Some Of The Gaps

You can notice a lot of common gaps forming in the month of July when the index was trading in a range of 8,300 to 8,650.

The range-bound activity finally ended when the index broke out of this range on 21 August with a breakaway gap. On 24 August, the index gapped almost 200 points lower. This and another gap that followed after a minor pullback are both examples of a runaway gap.

This downtrend finally halted around crucial support levels of 7,563 (the election result day high) and have witnessed a sharp pullback from those levels.  

The rightmost gap on the chart is from yesterday when the Nifty opened with an upward gap after the Fed announcement. It’s a bit too early to label what kind of gap this is but we will soon come to know when we see some more price action.

But now I hope that you and my friend have a better understanding of gaps and will be able to spot them in their various forms.

Have you noticed gaps on the technical charts of stocks or indices? Share your views in the Club or share your comments here.

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4 Responses to "Mind the Gap"
20 Sep, 2015
Its easier to teach as can been seen in this post..everything in hindsight seems nice and in order. when gap came on 18th its difficult to tell what will happen..so much for this post..!! sorry but writing a detailed article is different from real market.Like 
Arun Kumar Ghosh
20 Sep, 2015
It is an informative article and very nicely explained.Gives an insight of trend changes that ocular. Thanks a lot. Like 
20 Sep, 2015
Greetings, Nice to read about the gaps, I have studied a Fin. report, of Warren tea ltd. n its movements Now CMP- 182. i need to understand, if these, stock will go up frm these levels( from long term view) thanks maheshLike 
19 Sep, 2015
I understood the gap n its kind. But how it plays role in identifying the future probability of nifty or any stock, if one still has to wait for nifty movement in coming days to find out the gap???? So at any point of time, explanation of past is done well, but for future it becomes wait n watch.Like 
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