Anyone who has ever looked at a price chart has more than likely seen a gap—an area on a price chart where there were no trades. On a daily price chart, this normally occurs between the close of the market one day and the next day’s open. Gaps are the result of a temporary supply/demand imbalance, with prices dropping or rising sharply until balance is restored. This imbalance can be caused by many things, such as an after-hours earnings report that is significantly higher or lower than expected. Investors place orders for the next day based on the news, resulting in a gap between one day’s close and the next day’s open.
In this installment of Technically Speaking, we discuss four types of gaps—common, breakaway, runaway and exhaustion.
Common gaps are just that, common, and are usually non-events. Common gaps are also sometimes referred to as trading gaps or area gaps and tend to “get filled” fairly quickly. “Getting filled” means that the price action following the gap usually retraces at least back to the price prior to the gap. Figure 1 illustrates a common gap that is eventually filled or closed for Bed Bath & Beyond (BBBY). We can see that after the gap, prices come back down to the level at the beginning of the gap, thereby closing or filling the gap.
Common gaps usually appear in a trading range, where there isn’t any real buying or selling interest in the stock.
Whereas the common gap produces few trading opportunities, the breakaway gap is, arguably, the most significant gap. As the name implies, breakaway gaps occur when prices are breaking out of a pattern, the implication of which is important.
In mid-May, however, the supply/demand balance changed and the stock gapped downward on May 17, 2011, losing over 7% on that day. On the gap breakout, volume, which has been averaging around 16.3 million shares, spiked to 100.4 million shares that day, its highest level since the previous August. Such heavy volume to the downside on the breakaway gap was a clear bearish signal for HPQ shares.
While a gap is defined by the space in prices, volume plays a pivotal role as well. First, higher volume associated with a gap confirms the significance of the gap. Second, volume plays a role in defining future support and resistance levels following the gap breakout.
On May 17, 2011, HPQ shares opened at $37.57 after closing the previous day at $39.80. The shares fell to a low for the day of $36.04 before closing at $36.91. The huge volume associated with that price level will define where subsequent resistance should be expected to develop.
As would be expected, HPQ tested the mid-37 level a few times over the next several weeks, but was never able to advance any higher. Volume at this level on the breakaway gap marked that approximate price level as resistance.
Runaway gaps—also called measuring gaps—are generally caused by increased interest in a stock. Runaway gaps during an uptrend usually represent traders or investors who missed out on the initial upward move. They had been waiting for a pause in the upward move or even a price retracement, but eventually gave up. This increased buying interest forces the price to gap upward above the previous day’s close. Figure 3 shows a runaway gap for Bed Bath & Beyond (BBBY) in early April 2011. BBBY shares had risen roughly 10% in less than a month, and then on April 6, 2011, the company issued forward earnings guidance that was in line with analyst expectations. This guidance apparently reassured investors, as volume shot up to 12.1 million shares after averaging 2.8 million shares a day, and BBBY shares gained 10.4%.
Lastly, exhaustion gaps occur near the end of an up- or downtrend. Often they are the initial signal that the trend is coming to an end. Like other gaps, exhaustion gaps are accompanied by high volume and a large price difference between the previous day’s close and the next day’s opening price. It is easy to mistake a runaway gap for an exhaustion gap until the trend reverses itself.
Figure 4 shows an exhaustion gap that developed for MSC Industrial Direct Company (MSM) in early April 2011. In less than two weeks MSM shares had risen almost 11%; then on April 6, 2011, the company issued third-quarter 2011 guidance that exceeded analyst expectations. That day, MSM shares gained 6.4% on 1.9 million shares traded. The average daily volume at the time had been 280,000 shares.
However, as is the case with most exhaustion gaps, this gap was filled in quickly—within four days to be exact—as profit-taking led to a drying up of the demand that was driving the price higher.
Gaps can provide useful insight into the underlying trend in prices. In order to fully understand gaps and correctly read the signals they are providing, it is important to understand the behavior of the market as well as that of the underlying stock.
By familiarizing yourself with the price behavior of a given stock—especially with regard to the way prices behave when a gap occurs—you have a useful trading tool at your disposal.