Gap Wave Theory
Gaps occur because of underlying fundamental or technical factors. For example, if a company’s earnings are much higher than expected, the company’s stock may gap up the next day. This means the stock price opened higher than it closed the day before, thereby leaving a gap. In the forex market, it is not uncommon for a report to generate so much buzz that it widens the bid and ask spread to a point where a significant gap can be seen. Similarly, a stock breaking a new high in the current session may open higher in the next session, thus gapping up for technical reasons.
Gaps can be classified into four groups:
- Breakaway gaps occur at the end of a price pattern and signal the beginning of a new trend.
- Exhaustion gaps occur near the end of a price pattern and signal a final attempt to hit new highs or lows.
- Common gaps cannot be placed in a price pattern – they simply represent an area where the price has gapped.
- Continuation gaps, also known as runaway gaps, occur in the middle of a price pattern and signal a rush of buyers or sellers who share a common belief in the underlying stock’s future direction.
To Fill or Not to Fill
When someone says a gap has been filled, that means the price has moved back to the original pre-gap level. These fills are quite common and occur because of the following:
- Irrational exuberance: The initial spike may have been overly optimistic or pessimistic, therefore inviting a correction.
- Technical resistance: When a price moves up or down sharply, it doesn’t leave behind any support or resistance.
- Price Pattern: Price patterns are used to classify gaps and can tell you if a gap will be filled or not. Exhaustion gaps are typically the most likely to be filled because they signal the end of a price trend, while continuation and breakaway gaps are significantly less likely to be filled since they are used to confirm the direction of the current trend.
When gaps are filled within the same trading day on which they occur, this is referred to as 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 significantly higher than its previous close). Now let’s say, as the day progresses, people realize that the cash flow statement shows some weaknesses, so they start selling. Eventually, the price hits yesterday’s close, and the gap is filled. Many day traders use this strategy during earnings season or at other times when irrational exuberance is at a high.
How to Play the Gaps
There are many ways to take advantage of these gaps, with a few strategies more popular than others. Some traders will buy when fundamental or technical factors favor a gap on the next trading day. For example, they’ll buy a stock after hours when a positive earnings report is released, hoping for a gap up on the following trading day. Traders might also buy or sell into highly liquid or illiquid positions at the beginning of a price movement, hoping for a good fill and a continued trend. For example, they may buy a currency when it is gapping up very quickly on low liquidity and there is no significant resistance overhead.
Some traders will fade gaps in the opposite direction once a high or low point has been determined (often through other forms of technical analysis). For example, if a stock gaps up on some speculative report, experienced traders may fade the gap by shorting the stock. Lastly, traders might buy when the price level reaches the prior support after the gap has been filled. An example of this strategy is outlined below.
Here are the key things you will want to remember when trading gaps:
- Once a stock has started to fill the gap, it will rarely stop, because there is often no immediate support or resistance.
- Exhaustion gaps and continuation gaps predict the price moving in two different directions – be sure you correctly classify the gap you are going to play.
- Retail investors are the ones who usually exhibit irrational exuberance; however, institutional investors may play along to help their portfolios, so be careful when using this indicator and wait for the price to start to break before taking a position.
- Be sure to watch the volume. High volume should be present in breakaway gaps, while low volume should occur in exhaustion gaps.
- Gaps are spaces on a chart that emerge when the price of the financial instrument significantly changes with little or no trading in-between.
- Gaps occur unexpectedly as the perceived value of the investment changes, due to underlying fundamental or technical factors.
- Gaps are classified as breakaway, exhaustion, common, or continuation, based on when they occur in a price pattern and what they signal.