What are Gaps in Stock Market?

Last Updated on September 23, 2023 by BFSLTeam BFSLTeam

How to Understand a Gap?

A gap in stock market is a break in a security’s chart where its price jumps or drops from the previous day’s close without any trading in between. Gaps happen when news or events change the market fundamentals during hours when markets are usually closed, for example an after-hours earnings report. 

What Are Gaps In Stock Market?

Gaps in stock market usually happen when a news or event triggers a surge of buyers or sellers into the security. It makes the price open much higher or lower than the previous day’s closing price. Depending on the type of gap, it could signal either the beginning of a new trend or the end of a previous trend. Gapping means that the price of a security or asset opens far above or below the previous day’s close with no trading activity in between. Partial gapping means that the opening price is higher or lower than the previous day’s close but still within the previous day’s price range. Full gapping means that the open is outside of the previous day’s range. Gapping, especially a full gap, shows a strong change in sentiment happened overnight. Some traders use it as a strategy to make money from playing the gap when such a situation happens.

Also Read: Defensive Stocks

Types Of Gaps In Stock Market And How to Distinguish Between Them

There are some key differences between the different kinds of gaps: Common Gaps, Breakaway Gaps, Runaway Gaps, and Exhaustion Gaps. 

• Common Gaps

Generally, common gaps do not have any major event that causes them. They usually get filled quickly (usually within a few days) compared to other kinds of gaps. Common gaps are also called “area gaps” or “trading gaps” and they have normal average trading volume. 

• Breakaway Gap

A breakaway gap happens when the price gaps above or below a support or resistance level, like those formed during a trading range. When the price breaks out of a well-defined trading range with a gap, that is a breakaway gap. A breakaway gap can also happen out of another type of chart pattern, such as a triangle, wedge, cup and handle, rounded bottom or top, or head and shoulders pattern. 

• Runaway Gap

A runaway gap, often seen on charts, happens when trading activity skips sequential price points, usually driven by strong investor interest. In other words, there was no trading, meaning no change of ownership in a security, between the price point where the runaway gap started and where it ended. 

• Exhaustion Gap

An exhaustion gap is a technical signal marked by a break lower in prices (usually on a daily chart) that happens after a fast rise in a stock’s price over several weeks before. This signal shows a significant change from buying to selling activity that usually matches with falling demand for a stock. The meaning of the signal is that an upward trend may be about to end soon. Each kind of gap has certain implications for traders. For example, reversal or breakaway gaps are usually followed by a sharp increase in trading volume, while common and runaway gaps are not. Also, most gaps happen because of news, or an event such as earnings or an analyst’s upgrade/downgrade.

Common gaps occur more often and do not always need a reason to happen. Also, common gaps tend to get filled, while the other two gaps may indicate a reversal or continuation of a trend.

The Drawbacks of Gaps

Gaps in stock market are easy to see, but they have limitations. The main problem is one’s own ability to tell the difference between the kinds of gaps that happen. If a gap is misunderstood, it could be a terrible mistake that makes one miss a chance to either buy or sell a security, which could affect one’s profits and losses.

Also Read: Adjusted Closing Price?

What Does It Mean to Fill a Gap?

A gap is filled when the price moves back to the original level before the gap. This happens often and it can be because of the following:

• Emotional reaction: The initial spike may have been too optimistic or pessimistic, so it needs a correction.
• Technical support: When a price moves up or down sharply, it doesn’t leave behind any support or resistance.
• Price pattern: Price patterns are used to identify gaps and can tell you if a gap will be filled or not. Exhaustion gaps are usually the most likely to be filled because they show the end of a price trend, while continuation and breakaway gaps are much less likely to be filled because they confirm the direction of the current trend. When gaps are filled on the same trading day that they happen, this is called fading. 

For example, let’s say a company announces great earnings per share for this quarter and it gaps up at the open (meaning it opened much higher than its previous close). Now let’s say, as the day goes on, people see that the cash flow statement has some weaknesses, so they start selling. Eventually, the price reaches yesterday’s close, and the gap is filled. Many day traders use this strategy during earnings season or at other times when emotions are high.

Some Tips for Trading Gaps in Stock Market:

• When a stock starts to fill the gap, it usually won’t stop, because there is no support or resistance nearby.
• Exhaustion gaps and continuation gaps mean the price will move in opposite directions—make sure you know what kind of gap you are dealing with.
• Retail investors often get too excited or scared; however, institutional investors and algorithmic systems may join them to help their portfolios, so be careful when using this indicator and wait for the price to break before taking a position.
• Pay attention to the volume. Breakaway gaps should have high volume, while exhaustion gaps should have low volume.

Also Read: Stock Symbol

Conclusion

A gap in stock market is a break in the market price of a security where it jumps to a different price level, either higher or lower, without any trading in between. A gap can happen when something unexpected affects the market, such as a comment from a senior Fed official about the interest rates. When the news comes out, markets may react quickly, with market makers withdrawing their bids and offers. This may cause a gap from the last price at ₹25.20 to ₹26.50, for example.