Gaps can appear on a chart for a number of reasons, and their causes can vary. But they can be useful to analyse as they can provide future levels of support and resistance, price targets or signal a reversal.
For example, a gap can appear on a daily cash market such as the S&P 500 (US500) due to out of hours trading activity. Its quite common for companies to release earnings when the underlying cash market is closed so, if these earnings deviate too far from expectations, it can make an impact on the cash market at the next open.
Fundamental data can also create gaps on intraday timeframes. Liquidity will typically dry up in the lead up to an economic event and, once volatility returns, it can push prices far and fast which leaves gaps for future reference.
With that in mind, there are three types of gaps we’ll demonstrate which tend to appear in separate parts of a trend.
- Breakaway gap
- Runaway gap
- Exhaustion gap
As the name would imply, a breakaway gap forms part of a breakout from a technical pattern such as a head and shoulders reversal, double bottom, or break of a trendline. What makes them significant is they can appear at the beginning of a larger move. It is therefor one of the more important gaps to monitor as it can help traders hop onto a strong trend at a relatively early stage.
A rule of thumb, the size of the breakaway gap can be assumed to be relative to the subsequent move. It is also desirable to see breakaway gaps be confirmed with an increase in volume (trading activity) to show fresh orders entering the market to support the move. This is not necessarily the case for a bearish gap on an index, although it is nice to see if it appears.
Given the nature of a breakaway gap, we would typically not expect to see them ‘filled’. By this we mean prices retrace to ‘close’ the gap before continuing in the direction of the breakout. In fact we could say that if a breakaway gap has been filled it reduced the chances of a strong trending move materialising, and that it is not technically a breakaway gap. That said, whilst breakaway gaps are not usually filled, price may retrace towards and attempt to close the gap before trend continuation resumes. Yet the more powerful breakaway gaps make no attempt to close before prices continue in the direction of the gap.
If prices are to close beneath an upwards gap, or above a downwards gap, we can say the gap has failed and look for evidence of a price reversal.
A more significant gap requires a strong fundamental driver. A great example for forex can be seen on EUR/USD following the exit polls of the French election in 2017. Emanuel Macron defeated far-right contender Marianne le penne to become French President, which dispelled fears of a populist movement across Europe and sparked a broad risk-on rally across European indices.
Relatively speaking, this is quite a large gap for EUR/USD which marked the beginning of a longer trend. As equity markets are more volatile we would typically expect larger gaps to appear on indices with fundamental drivers.
Runaway Gaps / Measuring Gaps
What separates runaway gaps from breakaway gaps are where they appear within a trend. Whilst a breakaway gap can initiate a strong directional move, breakaway gaps appear within an already established trend. Interestingly, they have a tendency to appear around the middle of a trend which allows the trader to project an approximate target for the end of that trend. For this reason, they are sometimes referred to as “measuring gaps”. Of course, this is not an exact science but the key point is that a runaway gap is a trend continuation signal which appears around the centre third of a trend.
A good example can be seen on WTI crude oil in February 2020. An OPEC meeting resulted in a fall-out between Saudi Arabia and Russia, creating fears of an oil price war. WTI gapped lower and endured its most bearish session since the Gulf War. Incidentally, the gap appeared around the half way point of the bearish trend.
As the name implies, exhaustion gaps are considered a sign of weakness and can appear at the end of a trends (although not always). Exhaustion gaps are part of another well-known pattern called an “island reversal”. In essence, a market has tried to continue in the direction of the trend after a gap, only to see prices reverse during a session then gap in the opposite direction to the trend.
Therefore, a true exhaustion gap requires two gaps to appear. The initial gap is before the high final swing and the second gap is after the final swing.
However, exhaustion gaps can at times be mistaken for runaway gaps as they do share similar characteristics. At least initially. But a decent indication that we are dealing with an exhaustion gap over a runaway gap is how quickly prices reverse against the initial gap. We would not expect a sharp reversal in a runaway gap, just as we would n expect a slow reversal as part of an exhaustion gap. Moreover, depending on the market the trader should also be able to identify a breakaway gap and runaway gap prior to an exhaustion gap.
In this example, the DAX (US30) gapped higher on Monday 3rd December. This would have appeared to be a bullish signal at the start of the session, but as it opened near the session high and closed lower, it had ominous signs at the end of the session.
The market opened lower the following day. Although it traded slightly higher and overlapped the prior session low, we would still consider it to be an Island Reversal given the depth of the sell-off by the close. Incidentally, prices continued to trade lower and even gapped lower again two sessions later.
Using Gaps as Support and Resistance
In this example, the S&P500 was trading within an established uptrend.
- It began to correct on the 1st of March over the next 36 sessions.
- It gapped higher to suggest a runaway gap had taken place.
- After trading marginally higher, momentum reversed and closed the gap. At this point, the trader would be on guard for a reversal.
- However, instead of accelerating lower the next session produced a bullish doji. Whilst the intraday low pushed lower initially, the open and close price remains above the open price of the gap.
- Prices then continued higher in line with the dominant trend.
- On the 3rd of January 2017, the DAX gapped higher. Given the low liquidity environment associated with this time of year, this gap would have been considered less significant. However, the longer a support or resistance levels holds the more significant it becomes.
- On the 17th January 2017, a failed intraday break of 11,482 support produced a bullish pinbar to show demand at this level.
- After rallying higher, momentum waned and prices retraced to gap support at 11,482. The trader could have taken a daily close beneath this key support level as confirmation of a reversal.
- The daily close beneath gap support did not materialise. Instead, support was respected and prices continued in the direction of the dominant trend.
Partially Filled Gaps
If a gap tried but failed to close a gap, it can be treated a swing point as part of traditional trend analysis. The following example on Bitcoin uses a 5-day trading chart (like the futures market) and not a 7-day chart of a crypto exchange. This means that weekend gaps for Bitcoin can appear on futures or derivatives CFDs as “out of hours trading” is conducted on cryptocurrency exchanges over the weekend.
- In this example, Bitcoin had recently broken to the upside of a symmetrical triangle.
- Prices then gapped higher in line with the triangle breakout.
- Prices began to fill the gap yet printed a large bullish engulfing candle on H4 before the gap was filled. This can then be used a potential support and treated as a higher low.
- After retracing back towards the low of the spike, support was confirmed at 11,178 as prices turned higher just points above this key level.
Using Gaps as a Reversal Signal
- Throughout March 2020 the Nasdaq 100 (along with many other indices at the time) were within a strong bearish trend.
- On Monday 23rd March the Nasdaq gapped beneath the prior swing low, which would likely be a bearish signal to a trend trader. However, a trader could have waited to see if the upper end of the gap was filled and then respected as resistance before initiating a short position.
- Whilst prices initially retreated higher, a strong bullish spike more than closed the gap which invalidated the bearish gap signal. At this point a trader could have stepped aside as their bias had not come to fruition.
- However, a counter-trend trader could also use this information to assume the trend had changed and jump on board a bullish move before a bullish trend was confirmed. On this occasion, not only did prices continue to trade higher the initial gap down marked the 2020 lows at the time. Whilst gap reversals are not always this powerful it does demonstrate how a closed gap can turn into a reversal.
Gaps in Forex
As forex markets trade 24 hours a day, 5 days a week, gaps appear less frequently. However, ‘weekend gaps’ can appear when markets open on Monday morning in New Zealand (which will be late night Sunday in the UK or Sunday afternoon in the US).
Quite often the gaps are small and can have a tendency to be ‘filled’. This in itself can create a simple strategy as the trader would identify the gap and seek to trade against the gap in hope that the gap will be closed. So the profit objective could be at or near the opposite end of the gap.
- In this example, AUD/USD gapped lower at the weekly open, yet immediately traded higher.
- The first 15-minute (M15) candle of the week was bullish with no lower wick to suggest the market was trying to close the gap. Prices initially teased with a break above the initial M15 candle.
- Bullish momentum returned and close the gap.
In this example, if the trader had set a buy-stop order above the initial M15 candle and targeted the low of the last M15 candle on Friday, a reward to risk ratio slightly above 1:1 would have been achieved.