Foundations of Trading: A Trader’s Journey [Part 8]
Welcome back to part eight of our blog series: A Trader's Journey! Today's blog will cover Josh's teachings from level 2 class 3. If you wish to review our previous blogs covering the Foundations of Trading classes, please click on the Foundations of Trading blog category on the right-hand side of the page. That will instantly bring up all the blogs from this series for you to review. Now for today's topic on the type of gaps, you can find on your candlestick chart.
What is a Gap?
A gap on a candlestick chart happens when no candlestick overlaps from the previous day's trading to the opening point of today's candlestick. Regardless, if a stock gaps up or down in price, there will be a blank area between the preceding day's candlestick to the opening day's candlestick.
In the image above, there is a gap between the previous day's closing price and the opening price of today's candle.
Cause and Effect
Now, a gap occurs typically during overnight or off trading hours and represents a sudden change in the perceived value of a company's stock. This shift in perspective is usually driven by company news, which in turn drives an influx of overnight orders. The influx of orders causes the stock to gap up or down when the market makers try to realign price points when the market opens fresh first thing in the morning. It should be noted that most gaps are bumps in the market, which will usually fill throughout the current day's trading.
The Types of Gaps
There are four main types of gaps: the common opening gap, the breakaway gap, the runaway gap, and the exhaustion gap.
The common opening gap is the most prevalent type of gap found in the wild reaches of the stock market. Since they can be found more often than other types of gaps, they rarely hold any weight or sway over the marketplace. Common opening gaps tend to be caused by stock liquidity, dividends, company earnings, or even a minor news story. These gaps almost always fill during the trading day.
The Breakaway Gap
The breakaway gap is the first of three major types of gaps, and they usually occur during a turnaround in the marketplace. This gap can be found after a significant reversal or consolidation pattern; it marks the beginning of a new trend and should have a high volume associated with it. It should be noted; this gap is one of the most profitable gaps for traders if played correctly.
The Runaway Gap
Unlike the breakaway gap, the runaway gap shows the market is moving well in a strong trend instead of marking a new trend. This means the runaway gap is seen as a continuation pattern of the current trend, and if the gap fails to fill, you simply trade in the direction of the move. This gap is sometimes referred to as the measured gap because you can measure the next phase of the stock's price action based on the most recent activity.
The Exhaustion Gap
At first glance, the exhaustion gap mimics the runaway gap, but what tends to happen is the volume driving the gap quickly evaporates, and the trend fails to gain any real momentum forward. Thus, the gap fills, and the stock levels out or even reverses. This gap can be found at the end of the market move and signals the end of the trend.
As with all major gaps, they are usually driven by a news story. A gap is considered major as long as the gap is still open and hasn't been filled by the current market moves. If the gap does fill, the odds of playing it out are minimal to nonexistent.
There are more patterns to be found on candlestick charts than gaps. However, gaps are a great place to start when it comes to training yourself to locate overall candlestick patterns. The great thing about patterns is where we find patterns, we find predictability, and where we find predictability, we find opportunity. As always, thank you for reading, and we will see you next week as we discuss my main takeaways from our next Foundations of Trading class!
