How to Identify Price Gaps in Trading
Price gaps can help determine your trading strategy. A price gap forms on a bar chart when the opening price of the current bar is above or below the closing price of the previous bar. Gaps occur mostly on daily charts, sometimes on weekly charts, and rarely on intraday charts. Depending on circumstances, gaps can show continuation and reversal patterns, and can signal opportunities to enter or exit a position.
Some gaps are obvious and some are subtle. For example, if the opening price is above the previous close but the low of the current bar is below the previous high, then those bars overlap and the gap is hard to spot. Many traders simply ignore that type of gap.
If, however, the low of the current bar is obviously higher than the high of the previous bar, that will draw the attention of most traders.
Gaps that occur within a trading range can be either a common gap or a breakout gap. If the gap occurs in the middle of the trading range, far from either the support or resistance level, it is a common gap. Common gaps occur frequently and are, well, rather common. They rarely provide meaningful trading opportunities. Ignoring them usually is the best policy.
Breakout or breakaway gap
When a stock price exceeds a high of a price range during a specific time frame or falls below the low during that same period and simultaneously forms a gap, traders describe that situation as a breakout or breakaway gap. A breakout gap often provides excellent trading signals to enter a new position, in the direction of the gap. The breakout gap above comes from a long-standing trading range.
A continuation gap is also known as a runaway gap or an acceleration gap. This type of gap occurs within an uptrend when the open price of the current bar is higher than the close price of the previous bar.
If the low of the current bar is also obviously above the high of the previous bar, this gap usually indicates that the trend is very strong. Continuation gaps may also occur in downtrends. The defining characteristics are opposite those of the uptrend.
Some short-term traders may use a continuation gap as a signal to enter a position in the direction of the gap. Position traders may use this same signal to confirm that a current trade remains viable.
You sometimes see a series of runaway gaps occur in close proximity to each other, and these gaps usually are a strong confirmation of the prevailing trend. However, continuation gaps also warrant caution, because they can turn into an exhaustion gap.
Exhaustion gaps occur at or near the ends of strong trends. Unfortunately, the defining characteristics for an exhaustion gap are virtually identical to those for a continuation gap.
Exhaustion gaps are often accompanied by very large volume, which is one clue that the gap may not be a continuation gap. Otherwise, distinguishing an exhaustion gap from a continuation gap is sometimes impossible, until the stock price changes direction. By that time, it is usually obvious that something is wrong with the trade and you should exit your position.
If the stock price continues its trend, it will become a continuation gap. If, however, the stock price reverses, the gap may be classified as an exhaustion gap. Sometimes, an exhaustion gap turns into an island gap.
An island gap, or an island reversal, forms when a trend changes direction. The pattern is actually two gaps that isolate either a single bar or a short series of bars from the dominant trend and the new trend.
An island gap usually is a good indicator that the prior trend has been extinguished and can be used to signal an exit from an existing position. You may also use an island gap to initiate a new position, but only if the direction of the new trend aligns with the stock’s underlying fundamental condition.