A gap is an empty space on the chart of an asset or a financial product. It reflects a sudden imbalance between supply and demand.
Contrary to what one might think, financial markets do not evolve in a linear and continuous manner. Certain discontinuities regularly appear between two stock market sessions, or even within the same session. These price gaps are not without consequences for investors. To trade well, it is therefore necessary to understand their origin and to learn how to interpret them.
What is a gap ? What are the different types of gaps ? How can you interpret them ? How can you protect yourself and take advantage of gaps ?
Here is a complete summary of the information you need to know to understand the origin of stock market gaps and learn how to manage these events.
By definition, the gap is a space left empty between two transactions.
When this price gap occurs between two trading sessions, it is called an overnight gap. In the particular case where it occurs between the Friday evening close and the Monday morning open, it is then called an overweek gap. Finally, when it appears during the same trading session, it is called an intraday gap.
A gap results from a sudden imbalance between supply and demand. Instead of moving continuously, prices jump up when buyers are in a strong position (bullish gap) or down when sellers are the strongest (bearish gap). News items can appear after the market closes and influence the valuation of financial assets, so it is natural that their quotations are not systematically the same when the market reopens. All equity markets that are closed at night can be affected by overnight gaps. A market like the foreign exchange market (FOREX) will be spared this type of gap, except for overweek gaps due to the weekend closure. A particularly representative example is certainly the corporate earnings season. As companies' financial statements are released during the market close, companies' shares usually reopen with a bullish gap when the release has positively surprised investors, or with a bearish gap when shareholders have been disappointed.
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Finally, as far as intraday gaps are concerned, the situation is somewhat different. Indeed, the liquidity of the market, i.e. the volume of trade and the quantity of buy and sell orders, plays a crucial role in the appearance of these gaps. Thus, all other things being equal, the more liquid a market is, the lower the probability of an intraday gap occurring, and vice versa. To observe an intraday gap, it is essential to set up your chart properly and to select a suitable time unit. A tick by tick chart or a "minutes" time unit will for example allow better observation of intraday gaps than a setting in "hours" time units where the gap could be hidden within a Japanese candlestick.
The most common type of gap, the common gap is not associated with a major event in the stock market history of a financial asset. Of modest size, it is generally quickly filled by the market.
A gap is "filled" when prices return to their pre-gap level.
The continuation gap appears during a trend movement and in the direction of this trend. It is therefore a bullish gap in an uptrend or a bearish gap in a downtrend. The high volumes often recorded during this type of event make it a difficult support or resistance to break through. For chart analysts, this type of gap, usually located in the middle of a trend, allows them to estimate the potential of the current trend, with half of the way to go.
The breakout gap marks the entry into trend of a financial asset. Large in size and accompanied by high volumes, it generally corresponds to strong economic news. Difficult to break through, this gap is the guarantee of the new trend. When it is filled, the future of the initial trend is strongly compromised.
As its name suggests, the terminal gap appears at the end of a trend and reflects investors' excessive optimism at the end of an uptrend (with the capitulation of the last sellers) or their excessive pessimism at the end of a downtrend (with the capitulation of the last buyers).
Gaps are a real danger for traders. In the absence of a continuous quotation, the stop-losses intended to cut the trader's losses automatically can be triggered much further than anticipated and thus generate important financial losses, especially for leveraged positions. To limit this risk, it is therefore essential to adopt good management rules. For example, the investor can avoid remaining in a position from one session to the next by adopting a day trading strategy. They can also choose to trade financial assets that are less exposed to intraday gap risks, for example by favoring stock market indexes over company shares.
Finally, the trader should consult the economic calendar at the beginning of each session to avoid being surprised by peaks in market volatility, for example during central bank announcements.
Although it is impossible to completely neutralize the risk associated with gaps, adopting good money management rules and knowing how to recognize the different types of gaps will already make it easier to navigate the markets.