Occasionally, there comes a point when the stock market closes for the night and re-opens in the morning and there has been no trading activity in-between for a particular share. This is called gapping. A gap stock has usually experienced an unexpected change in price overnight, due to external factors such as supply and demand.
The share market can be volatile and this results in frequent gaps in the market. Gapping most commonly happens overnight, although it can also happen during daily trading hours when there is a rapid jump in price of a stock. Stock gaps are caused by a number of reasons, such as earnings reports, news announcements and other economic indicators that lead to an increased supply and demand for the financial instrument.
What is gap trading?
Considering the above information, what does ‘trading the gap’ mean? In simple terms, traders identify gaps between opening and closing prices on a trading chart where there has been volatile action, and can use this to devise an appropriate trading strategy. They will then need to calculate potential entry and exit points for their trades. Traders often use event-based strategies when there is a market gap, as they can predict but not guarantee what will happen next.
There are also different classifications of gaps, as they do not all represent the same price pattern or trend on a price chart. These can be split into the following:
Breakaway gaps: these happen at the end of a pattern and signal the beginning of a new trend.
Common gaps: these represent an area where the price has gapped but nothing else.
Continuation gaps: these are caused by a rush in supply and demand that occur in the middle of a price pattern.
Exhaustion gaps: these happen near the end of a pattern and signal a last attempt to hit price highs or lows.
Stock gap analysis
There are two levels of gapping within the stock market: partial and full. Partial gapping is when a share’s opening price is higher or lower than the previous day’s close but within the typical range, whereas full gapping is when a share’s opening price is outside of the range. A full gap shows that the market was particularly volatile overnight and the market sentiment for this share has changed.
The imbalance between supply and demand of a particular stock pushes its price outside of support and resistance levels overnight, which leads to gaps in a chart. Sometimes, this gap is filled back to its original level. This can indicate that the price rally was misunderstood, too optimistic, or investors have had a more thorough look at the earnings report and spotted weaknesses. This can lead them to sell their positions, bringing the share’s value back to its original level.
How to find gap up stocks
Gap up stocks are relatively easy to spot on a price chart. Gaps in the market are shown as blank spaces between candlesticks and gap up stocks are followed by a green candlestick on the open. This shows that there is a rally in price, which can either signal a new trend or it may be an anomaly. Consider the example below, where a large space in the price chart is followed by a green candle, signalling that there has been an external event leading to the asset’s jump in price.
