Why Do We Trade Gaps? – Gap Filling Theory

What are gaps? Do we normally see gaps on a chart of stock while we are trading? Are all gaps created equal? There will just be as many questions as you can think of about this kind of behavior on stocks and before we go into anything let’s start with the definition of gaps.

What is a gap?

A gap can be defined as a dramatic price level change on a chart where no trading occurred. These can happen in all time frames but, for short-term trading, we are mostly concerned with the daily chart. Usually we can find that a gap on a daily chart happens when the stock closes at one price for the previous day but opens the following day at a very different price (significantly higher or lower ).

Here comes the questions – Why would this happen and how? This happens because buyers or sellers are actively trading during pre-market trading session and inevitably results a change on the default open price upon the opening bell. And these kinds of trading actions are normally associated with either a pre-market press release (normally shown as 8-K current report) or an earning conference call prior the opening of the day.

For example, in the morning of March 25th, Netflix tickered as NFLX reportedly got upgraded by one equity research firm with a Strong Buy Recommendation for a one year price target $225.00/share. As a result, NFLX was traded actively in pre-market with higher-than-average volume and the price jumped up to $184.00 from previous close price $180.00. Gap was formed.

A Typical Opening Gap up

Let’s look at another chart:

You can see on the chart above that the stock closed at one price and then the next day the stock “gapped down” creating a price void on the chart (grey rectangular area ).

Filling the gap

Sometimes you might hear us talking about a stock is “filling a gap” or there is a “gap to fill”  as we are discussing trading on our club facebook group.

But are you wondering what the heck we are talking about?

In Japanese Candlestick Charting gaps are referred to as windows. When we say that a stock is “filling a gap”, the Japanese would say that the stock is “closing the window”.

We were talking about a stock that has traded at the price level of a previous gap. Here is a chart example:

chart of filled gap

In this example, you can see that the underlying stock NDN gapped down after a negative press was released, however, a few days later it went back up and filled in the price level at which there were previously no trades. This is known as filling the gap.

Sometimes you will hear someone saying that “gaps always get filled”. This just simply isn’t true. Some gaps will never get filled, and sometimes it can take years to fill a gap.

For example, AAPL’s quarterly earning report gap down was never filled.

Types of gaps

I normally mark all the gaps on the charts of those stocks that I am currently watching at, however, it is not necessary for you to label and be familiar with all kinds of gaps because we can simply categorize them into these 3 types of gap.

  • Breakaway Gaps - This type usually occurs after a consolidation or some other price pattern. A stock will be trading sideways and then all of sudden it will “gap away” from the price pattern.
  • Continuation Gaps - Sometimes called runaway gaps or measuring gaps, these occur during a strong advance in price.
  • Exhaustion Gaps - This type of gap occurs in the direction of the prevailing trend and represents the final surge of buying or selling interest before a major trend change.

Plan Your Trades on Gaps

Trading gaps may or may not be easy and it could really depends on how you develop your own trading plan based the charts, technical indicators and your experience because every trader has different strategy and plan.

Bottom line: holding positions waiting for breakout or runaway gaps to be filled can be devastating to your portfolio. Likewise, waiting to get on-board a trend by waiting for prices to fill a gap can cause you to miss the big move.

Trade smart! Don’t let gaps find you! You find them!

Author: Chuhao Zhou
Boston University Trading Club
March 29th 2013

This entry was posted in Equity Reports, Market Analysis. Bookmark the permalink.

Leave a Reply

Your email address will not be published. Required fields are marked *

1 + 1 =

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>