Common Gaps : These gaps are named after the frequency with which they occur. They are also known as area gaps, pattern gaps, or temporary gaps. Common gaps often occur when trading is bound between support and resistance levels and market price tends to consolidate sideways. Common gaps usually get filled up fairly quickly.
Forecasting significance: Nil or very little trading opportunity provided.
An example of a common gap can be seen below.
In the above chart of HDFC Ltd, we observe a number of common gaps which occur with high frequency when the stock consolidates in a sideways zone.
Breakaway gap : These gaps occur when the price action is breaking out of a trading range or price pattern. The presence of the breakaway gap, depending on its direction, emphasizes the bullishness or bearishness of the breakout. A breakout of a trading range is the main distinction that separates breakaway gaps from other types of price gaps.
Forecasting significance: Implies that a genuine breakout has occurred, i.e. the buying demand is much stronger than the selling demand if an upward gap is witnessed. Volume plays a major role in confirming the breakout. A large spike in volume is a sign that large institutional investors - usually known as ‘smart money’ - have jumped on board the stock. This usually ensures that the stock price will be supported near the breakout level and the stock will continue to rise. Trading a breakout without volume is a risk.
Stop loss: Can be placed below the opening or intraday low of the breakout. This area generally acts as a support level, though the price will sometimes dip below the intraday low only to witness fresh buying which will support the stock. To reduce this risk, some traders place a stop loss below the top of the previous trading range if the gap formed is not too large.
Breakaway gaps may occur from an earnings surprise or any other significant corporate news announcement. Let us take a look at the example below:
In the above chart of Polaris, we witness a breakaway gap from a sideways price consolidation backed by a surge in volumes which confirms the breakout. Stop loss can be placed below the low of the breakout or a few points below the high of the previous day.
Continuation Gaps : They tend to occur during strong trends, i.e. near straight line advances or declines in prices. These gaps are either closed very quickly or tend to remain open for a significant period of time till the market witnesses a major reversal in the opposite direction.
Forecasting significance: Continuation gaps usually occur at the halfway point of a trend, and hence, can be used to measure the ultimate price movement. It is for this reason that they are also commonly referred to as measuring gaps.
Identifying a continuation gap:
Below is an example of a continuation gap.
Forecasting significance: Calculate the initial movement in the security. In our example, we calculate the distance from point A to B. Titan witnessed a movement of 115 points from 580 to 695, which is the midpoint of the gap. To determine the target price, we add this distance to the midpoint of the gap thus obtaining a target price of 810. The up-move in Titan was quite swift, managing to hit the target price on the same day as the continuation gap. Usually, the target is reached within a few days.
Exhaustion gap: As the name suggests, an exhaustion gap occurs at the end of a trend. In the case of an uptrend, the price makes one last attempt to move higher on the back of bulls; however, exhaustion is witnessed and the price is not able to sustain at higher levels.
Historically, it has been observed that exhaustion gaps can be dangerous as they tend to induce traders into a trade only to witness price move against the anticipated movement in the following days. In fact, an exhaustion gap signals the end of a trend. There are two probabilities in an exhaustion gap scenario: (i) the trend may reverse immediately, or (ii) price may remain in sideways consolidation for some time. An exhaustion gap signals a trader to exit a position but does not necessarily indicate the beginning of a new trend in the opposite direction.
Forecasting significance: It is difficult to differentiate an exhaustion gap from a measuring gap during formation. One factor to look out for is volume; large unsustainable volumes are observed with the price witnessing a trend reversal in the following days. An example of an exhaustion gap can be seen below.
We can witness an exhaustion gap in the above chart of Jubilant FoodWorks. Price witnesses a large gap during the uptrend and multi-month high volumes only to see a trend reversal in the following days, thus, trapping the bulls. Two back-to-back Doji candlesticks indicating indecisiveness are also witnessed right at the top. A close below the Dojis provides additional confirmation of a reversal in trend.
Island reversal: This does not fall under the category of gaps per se, but is a famous candlestick pattern formed due to gaps.
An island reversal is short-term reversal pattern that forms with two overlapping gaps. A bullish island reversal forms with a gap down: short consolidation in prices and gap up. A bearish island reversal forms with a gap up: short consolidation in prices and gap down. Technically, both the gaps should overlap to create an empty space above or below the island. Traders with positions between the two gaps are stuck with losing positions.
Identifying of an island reversal:
Forecasting significance: A long position can be initiated in case of an island bottom, while a short position can be initiated in case of an island top. The pattern tends to be quite reliable and has a good success ratio. It is also more trustworthy if the two gaps are very large.
Stop loss: A stop loss should be placed below the island bottom pattern when entering a long position and should be placed above the island top pattern while entering a short position.
Below is an example of an island reversal.
In the above chart, we witness a bearish island reversal pattern in Bharti Airtel’s price chart. Price gap is up but is unable to sustain the uptrend. After a few days of consolidation at the top, price corrects with a gap down formation. A short position can be initiated by maintaining the top of the island as the stop loss.