First, let's take a look at an illustration of a couple of chart gaps:
Good grief! It's like reading a riveting novel, only to find halfway through there are pages missing. Speaking of pages, we're gonna steal one from Douglas Adams here and impart his sage advice: Don't panic. Gaps are normal and common on graphs that track stocks and commodities. Gaps can be created anytime there's a marked difference in a commodity's value without any actual trading taking place. The most common reason for a gap is because some markets aren't open all the time; when they're closed—and no trading is taking place—a gap is formed.
But—you may well be saying—alternative currency markets are international, and they're always open for trading. Fair enough; there are other reasons gaps can form on a market chart. For example, gaps are often made when there's an extremely good—or extremely bad—earnings report issued. They can also be the result of an adjustment made by the analyst who created the chart; sometimes they decide to make changes to compensate for a minor error in their calculations. Our main point is: Even though gaps can be alarming in appearance, for the most part they're business as usual.
There are three major types of gaps; we'll help you familiarize yourself with them with the images to follow:
The above illustration shows a Breakaway Gap; specifically, one in a “bull,” or upward-trending market. Breakaway gaps are formed when there are brief periods of very high-volume trading. This type of gap occurs at the beginning of a new trend, which can be upward (as seen above) or downward (in a “bear” market.)
Here we have a look at what's known as a Runaway Gap. It's well named, because it represents an intensifying of a current trend. For example, the runaway gap depicted above takes place during an upward “bull” market trend. The trend is so sharp at one point—even without trading taking place—that the cap is created. Runaway gaps can also take place in a downward-trending “bear” market.
The Exhaustion Gap, as shown above, occurs at the tail end of an upward or downward trending market (this image here shows the end of an upward “bullish” trend). It shows up at or near the peak or valley in the commodity's value, which starts to trail in the opposite direction slightly afterward—though the trend reversal is rarely as intense as the trend immediately preceding it. Once again, the gap represents a sharp increase or decrease in value that isn't a direct result of trading for the brief period represented.
The exhaustion gap illustration helps us define another term that's unique to gap patterns. See where the gap is formed, indicated by the arrow? Directly to the right of that gap, you'll see the price has returned to the level it was before the gap was formed. When that occurs, the gap is said to be “filled.” A filled gap indicates a correction of the circumstances that created the gap in the first place—perhaps because investor optimism or pessimism proved to be unjustified. As you can see by the illustrations in this article, not all gaps are filled; this only happens in situations where a brief trend correction is required by the market.
Gap trading can be tricky, especially for new investors; sometimes they indicate trend reversals, and sometimes they don't really represent much of anything at all. If you'd like additional information on making investment decisions based on gap patterns, we heartily recommend to our readers this article by Investopedia. It's a perfect continuation of the concepts discussed here.
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