Gaps occur when a stock begins a new trading day at a price that’s vastly different from the previous day’s closing price. In effect, there is no trading at prices between the closing price and the opening price. This appears as a “gap” on a price chart.
Generally speaking, gaps up are considered positive and gaps down are considered negative. However, in many (but not all) cases, price gaps get filled. So if a stock gaps up, you might expect that at some later time (from minutes to months later) the stock will drift back down into the gap. Conversely, if a stock gaps down, it’s likely to bounce back up to fill or partially fill the gap.
Gaps typically offer support or resistance. If a stock gaps down, the gap will offer resistance if it attempts to recover. A gap up will provide support when the stock corrects. There are many types of gaps, but the two most important types are exhaustion gaps and breakaway gaps.
Exhaustion gaps signal the ends of major moves. They are associated with rapid advances and declines. If, after a long and powerful move, a gap is created, it’s probably an exhaustion gap. To be sure, look for huge trading volume. As its name implies, an exhaustion gap typically signals the end of a major move and that a reversal of trend is imminent. The camp that is in control (buyers or sellers) has exhausted itself in a last-ditch effort to push the stock. Once this occurs, the other camp quickly takes control and the stock moves in the opposite direction.
A great example of this can be seen in figure 7. Our example stock surged from the mid-teens to a high above sixty in just 17 weeks! But notice the gap that was created at the high. Once the buyers ran out of steam, the sellers pounced on the stock, causing a major trend reversal. This is a classic exhaustion gap.
Breakaway gaps signal the beginning of a move. They typically occur when a stock that’s been basing (moving sideways) breaks out of the base with such power that a gap is created in the price chart. Breakaway gaps are important because they typically portend higher future prices.
In many cases, a breakaway gap will not get filled. The buying is so intense that the gap marks the beginning of a significant upmove in the stock. See figure 8.
Breakaway gaps can also occur when a weak stock has been forming a base down near its lows. If support is broken with such intensity that a gap is created on the price chart a negative breakaway gap is created. This will likely mean significantly lower prices are on the horizon.