Theory of Gaps - Gap ups and Gap downs

Due to the high volatility in the market, we are getting many gap ups and gap downs. Thus, here I come with something that explains to you what the gaps are and why they creates on the chart.

What is a Gap?

A gap is no trading zones on the technical charts. Gaps are formed because of news flow after the market closes and before it opens. The largest gaps occur in bear markets. Bull market gaps do well when they appear near the yearly high. Large gaps perform better than small ones.

There is a common myth that coming from inception that a gap is always filled. The believer of that can cost a good sum of money as way back in 2013 Nifty has created a gap from 5450 to 5550, which is yet to fill.

Types of Gap

  • Area or Common gap
  • Breakout gap
  • Runaway gap or Measuring gap
  • Exhaustion gap.

Area or Common gap

They simply represent an area where the price has gapped. These types of gaps cannot be placed into the price pattern.

Breakaway gaps

These types of gaps created after a breaking a consolidation phase, Trendline or a major support or resistance. This type of gap can be used for trading if it spotted at the right time. It comes after a Breakout or down of major support or resistance or consolidation phase, that indicates the trend changing. Generally, a sharp move is associated with it.

Gaps on the Graph

Runaway or Measuring or Continuation Gaps

This type of the gaps appear in an ongoing trend and when it happens, it just exacerbates the trend, accompanied with high volume. In the above chart of the Nifty, you can notice, first, a breakout gaps came that changes the trend then Runaway gap appeared which made the selloff very fast.

Exhaustion Gaps

This gap generally occurs at the top or bottom of the trend. The sentiment of the market at that time is so high either buying in case of uptrend or sell at the bottom. If such gaps occurs followed by reduced volume, this could be the first sign that we are at top or bottom. Generally, it comes and make an end of the prior trend.

In the above graph, you can notice a gap up at the top then a big downtrend came into the play.

Island Reversal

It is a combination of the exhaustion gap followed by breakout gap. You can see in the below image first gap down says a breakdown and after consolidation another gap come but this time in upside. These kinds of gaps are known as Island Reversal. The same pattern can be identified in the opposite case that is first you can see a bullish break out followed by consolidation and a bearish breakdown. Such gaps can change the trend.

Series of Gaps (usually seen in indices)

It is a series of gaps. When a stock or indices go through a major trend bullish or bearish, you see every other the it is opening gap up or gap down this go through for some times.

Bottom Line
1. Creation of gaps results in volatility. Stop-loss in trade might be deep.
2. You should not jump in start trading on gaps after reading this. Instead, do your research, followed the stock closely and develop a strategy to trade them.
3. One should not follow this without backtesting. Blind follow may cost on your capital. 

Do you trade Gaps and how? Write us into the comment box.

Highly recommended to learn these topics before delving into option trading.

**Some part of this post is taken from Gautam Majumdar Sir Twitter.

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