As the name suggests, common gaps are generally of no significance; they are frequently found on price charts. They can be caused by a stock going ex-dividend. Common gaps are generally “filled” within a short period of time. Filled is the common term for when the price retraces back to the previous level and closes the gap. It is important to be able to recognize common gaps and not fall into the trap of thinking that they are signals of market strength or weakness.
Breakaway gaps are the ones that astute traders watch for because they can be used to identify the beginnings of a trend. Let’s first look at where we find this type of gap. Generally speaking, breakaway gaps occur at the completion of an important pricing pattern and signal the commencement of a significant market move. Markets often get caught in congestion areas (i.e., an area in which prices range trade for a short period of time as prices fail to penetrate support and resistance levels).
To break out of theses areas requires market enthusiasm (either positive or negative) or a fundamental development that causes prices to “break out”. Breakaway gaps usually occur on heavy volume. A stronger signal is given if volume does not build until the gap occurs. The point of the breakout now becomes the next support level (upside breakout) and resistance (downside breakout).
It is important at this point to correct a myth commonly associated with gap analysis that “gaps are always filled”. This simply is not true. As a rule, breakaway gaps are not filled because the market has shifted direction.
Runaway Gap (aka Continuation Gap)
After a market has found direction and the trend is established, it is common for a runaway gap to occur. The reason this type of gap develops is that interest in the market increases as traders waiting for the pull-back give up and decide to buy in instead.
In an upward trending market, runaway gaps are a sign of strength and, in a downward tending market, a sign of weakness.
Runaway gaps are used by some traders as a way of “measuring” how much further a trend has to run. The most common method is to use the distance from the start of the trend to the gap as the half way point on the length of the trend.
Exhaustion gaps are those that appear near the end of the trend and occur after the other two types of chart gaps have been identified. They are identified by high volume and large price difference between the previous day’s close and the new opening price.
They are often mistaken for a runaway gap rather than as a signal that the trend is nearing an end.
Exhaustion gaps occur as the market enters a state of panic and prices move sharply; investors pile in on the idea that the market is about to run away rather than correctly seeing that the trend is almost complete. Exhaustion gaps are identified by the exceptionally high volume of trading and the fact that the gap is filled within a short time frame (i.e., when prices close under the last gap). Exhaustion gaps are a signal that the market is at a turning point.