How to use the gaps in stock charts to make money: NEPSE Investing Guide S01E13

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Gaps are mysterious and unique parts of a stock chart. They are like holes in an otherwise continuous chart pattern.

Simply, a gap is a price level or area at which no shares were traded. As a result, no figure is formed in the stock chart. Thus, one will only see a blank space. A gap in a stock chart is mysterious because, for some reason, no buyer or seller could execute a transaction at that price level.

A gap can form during an aggressive bullish surge. A gap is seen in the candlestick chart of National Life Insurance Company Limited.
Candlestick chart of National Life Insurance Company Limited.

There are different types of gaps seen in a stock chart. They vary based on where they form and what they tell about the future.

Before we discuss the types of gaps seen in stock charts, here are some points you should consider:

a) It is only a myth that a gap must be fulfilled. In fact, a stock has the probability of coming back and “filling the gap” as it has to reach any price level. Some gaps are never fulfilled.

b) Gaps formed after dividend and right share adjustment are not significant because they are not caused by a change in supply-demand relation that governs the trend. Thus, while analyzing a stock chart, use the adjusted version that discounts these changes. Sharesansar and NepseAlpha give you the option to use an adjusted version of every chart. Always use that version.

c) If a stock chart has multiple, frequently occurring gaps, none of them is significant. They are just a result of thin investor activity.

Now that these things are clarified, let’s discuss the types of gaps.

Common Gap or Area Gap

Common or Area gaps are formed inside a congestion pattern. Congestion patterns are those patterns that become smaller and smaller with each session along with the decline of investor activity. A symmetric triangle is a perfect example of a congestion pattern.

An area gap is seen inside the symmetric triangle in the candlestick chart of Muktinath Bikas Bank Limited (MNBBL)
An area gap is seen inside the symmetric triangle in the candlestick chart of Muktinath Bikas Bank Limited (MNBBL). Notice how the gap is filled in the upcoming sessions. To fill a gap means to have investor activity in that horizontal price level.

Since volume gradually declines in such patterns, it is logical to get a gap because of thin investor activity. Also, the upper resistance is the zone of sellers and the lower support is the zone of buyers. Since the middle area is a no-man’s land, gaps are generally formed in such area. This is also why they are called area gaps.

Area gaps or common gaps are usually fulfilled. They also do not have much forecasting significance. Thus, the only useful thing to conclude if you see an area gap is that the gap will be filled soon. Thus, expect to have more movement around that horizontal price level.

Although a rectangle formed inside a trend channel does not become smaller with each session, it may also be considered a common gap.

Candlestick chart of Siddhartha Bank Limited (SBL). Gaps formed inside a trend channel are also area or common gaps. They will be fulfilled.
Candlestick chart of Siddhartha Bank Limited (SBL). See how the gap is eventually filled before the stock went up.

Breakaway Gap

Most breakouts from a horizontal price boundary will be attended by a gap. They are called breakaway gaps.

However, some breakaway gaps will go unnoticed because they happen during intraday, not between the closing of a day and opening of another day. (This is hard to understand in the beginning. Read the line again.)

Breakaway gaps demonstrate a greater strength of a breakout. This is because false moves are seldom attended by a gap. Thus, if you see two companies, both of whose charts are signalling a breakout, always choose the one with a gap. It makes the trend so much stronger.

Candlestick chart of Gurans Life Insurance Company Limited (GLICL). The breakaway gap formed during the breakout from the black resistance line signifies strength. Notice how the stock gained aggressively after that.
Candlestick chart of Gurans Life Insurance Company Limited (GLICL). The breakaway gap formed during the breakout from the black resistance line signifies strength. Notice how the stock gained aggressively after that.

Whether a breakaway gap will be filled depends on the trading volume before and after a gap has formed. If the volume was high before the gap but declined after it, there is a 50% chance that the gap will be filled before any decisive action is seen.

Continuation Gap or Runaway Gap

Notice how the trend continues after the gap. A continuation gap signifies that the trend is still strong and investor optimism is high.

A continuation gap or a runaway gap is less frequent but has more technical significance.

This gap is formed in the middle of a rapid advance or decline. In a rapid advance, volume is at the highest during the start, declines in the middle, and again rises in the final gasp. Continuation gaps form slightly above the midpoint of this swing.

They are called continuation gaps because they signify that a trend will last for a few more sessions before going through a consolidation or a reversal.

However, continuation or runaway gaps should be carefully scrutinized to distinguish them from exhaustion gaps. Exhaustion gaps occur near the end of an uptrend and signal a reversal instead.

Exhaustion Gap

An exhaustion gap occurs during a rapid advance or decline just like a continuation/runaway gap. However, the difference is that the trend weakens after the appearance of an exhaustion gap.

In the segment about continuation/runaway gap, we discussed how a trend gains volume at the start, then activity declines in the middle, before the final rise in volume in the final gasp. However, some trends may show a consistently solid momentum before hitting a stone wall of excess supply. The gap formed in such a movement might be an exhaustion gap.

Contrary to common logic, if the trading activity amounts to an extraordinary height during the day after the gap, the gap is most probably exhaustion type.

Exhaustion Gap
Exhaustion Gap

Also, an exhaustion gap is usually preceded by at least one continuation gap. This means that, during an uptrend, if another gap appears after the first continuation gap, you should be careful. The second gap might be an exhaustion gap. Thus, the more gaps you see, the more suspicious you should be.

Exhaustion gaps are quickly closed within two or three days and the trend might even reverse. However, an exhaustion gap does not necessarily mean reversal. It is just a halt. However, since some area patterns or consolidation are expected to form, it is better to get out of the stock and enter only if the buy signal reappears.

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