Gaps

Gaps: A gap is created when the low price on one day is above the high price of the previous day, or when the high price of one day is below the low of the previous day. Usually the market will try to fill a gap within 2-3 days of its creation. If not, it generally means that the market will have more momentum in the direction of the gap. Note: It is assumed that the markets studied for technical analysis, and especially gaps, have enough volume to provide liquid markets. Often, thin markets will have many gaps simply because there isn't enough trading to provide thorough price discovery.

• The common gap. The common gap is usually created by a surprise event or news not expected by the market. These are quite common and can occur at anytime.
• The breakaway gap. This usually shows the beginning of a major move. Upward gaps usually have
  heavy volume, more so than downward gaps. Breakaway gaps usually develop from rumors or unexpected news. They can be sudden and catch traders by surprise, causing them to chase the market, which is usually why they are not filled.
• The measuring gap. It signifies the rush of traders who have not yet gotten aboard the market because they were waiting for the original breakaway gap to be filled. Because the market continues to move away from them, a sort of panic sets in, and they become willing to pay almost anything to get in on what they think is a great opportunity. This in turn causes prices to move even faster which creates the runaway gap. It often happens about midway through the entire move, which is why it can be used for measuring a price projection. The rule of thumb is 'the move before the gap equals the move after the gap'.
• The exhaustion gap. This gap represents a major reversal in the market. Since a market that sees this kind of gap is almost always oversold or overbought, a correction is usually forthcoming. These markets are typically very volatile and extremely difficult to trade, and logically should be avoided.

Figure 9 shows many examples of gap formations and the ensuing moves. Gaps are very important chart formations. If the primary function of a market is to provide an efficient means of price discovery, then in theory, every price level should be traded. Gaps are areas where prices have not traded, and therefore the market should come back to fill them. If the market makes an attempt to fill and can't, it usually signifies that the resulting move will have much more momentum behind it. This is very useful in establishing positions after gaps. One can look to

buy a market on a correction to the gap with a stop below the low that established the gap. Typically the trade is low risk (small stop) and one can get aggressive with the trade. This type of formation has shown itself quite often in weather markets. In Figure 9, we see the market gapped higher in December '99. It then spent several days trying to come back into the gap and fill it. This would have been a low risk trade as entry would be just above the gap area with a stop below the swing low.

This particular gap also has an added significance in that it is part of an island bottom. Islands can be just one day or several days, or even weeks. They are formed when the market has a gap both before and after a price range, and neither gap gets filled. Islands take on even more importance than just single gaps because they signify a market that typically is at the end of a move, and strong move is about to begin the other way. Figure 9 also illustrates two islands that led to significant moves in the opposite direction. Islands should be viewed as aggressive trading opportunities with stops past the swing high.