Foundations: The Anatomy of a Gap

The main focus for blogging our way through the entire Foundations of Stocks and Options course is to provide a look behind the curtain on what each class has to offer. I tend to write about the one part of the class which strikes home in an “I didn’t know that” or “that’s kind of cool” fashion, and since I am going through FOSO Level 2 for the first time, there has been a lot of those moments.

I have been actively trading as I learn from the FOSO classes, but up to this point, my trading strategies have been nonexistent. The recent rampant market volatility made it easier to set trades and make a few dollars in a day, which you can review all my trades, which I executed while I blogged about FOSO Level 1 here. However, as I reviewed various company stock charts, reoccurring shapes and patterns started appearing, and the most prominent pattern was the gap which is covered in Foundations of Stocks and Options Level 2 Class 4.

The Anatomy of a Gap

A major gap on a candlestick chart happens when there is no candlestick overlap 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 closing price of the previous day to 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 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 gaps 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, 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 it 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 the Foundations of Stocks and Options Level 2 Class 5!