There is general knowledge of gaps but most people do not know enough about the many types of gaps and their respective importance. The understanding of gaps begins with the gap theory. But while the gap theory deserves a thorough discussion, I want to focus on the types and relative importance of the many different gaps and leave a detailed treatise on the Gap Theory to another time. Nonetheless, a quick lesson on the theory is warranted to set the stage. First off the definition of a gap is when the closing price and the following opening price is different. There are true gaps and body gaps just to name a few but a quick run through of the gap theory will serve to set the stage.



THE GAP THEORY

The gap theory simply states that there is a pattern to gaps. Gaps usually come in groups of 3-4. Typically a gap will happen in conjunction with a change of direction or at a break out above a support or resistance. The gap is followed by a run in the direction of the gap. The absence of news enhances the importance of the gap because there is always some news associated with a gap and if it is not common knowledge at the time, the news is privy to some influential folks ands will eventually hit the street at which time the public gets it's chance to respond which is often the occurrence of the next gap. Number two gap is a continuation gap and often there is a second continuation gap. The final gap is referred to as an exhaustion gap and it is generally near a support or resistance area. The idea of a final gap implies that the directional move / trend is running out of steam and a reversal is eminent.

FILL RATE

The strength and importance of a gap is generally judged by how quickly it is filled. Because opening gaps happen so frequently, a gap that fills the next day or in a few days is not much more important than one that fills in a few hours.

BODY GAPS

A Body Gap happens when the bodies (the space between the open and close) of two consecutive days have no common price activity. The high and the low however overlap so that at the end of the day there is no un-traded area.

TRUE GAPS

A True Gap leaves an area of un-traded prices so that you can draw a horizontal line between two days and not contact anything.

CLEAN GAP / DIRTY GAP / BREAK AWAY GAP

A Clean Gap is one that does not have any recent overlap. Recent is a relative term but typically, if there is a trend in place a clean gap will not gap part of the existing trend, rather it will extend the trend.

A Dirty Gap is a gap over recently traded prices. Often a gap happens at the resumption of a trend. The trend will retrace a bit and then re-ignite. This is a dirty gap and while the gap is important and the trend is reaffirmed, the gapping of recently traded prices is not as significant as the clean gap.

A Break Away Gap is a clean gap and a true gap that extends the trend into new territory. It breaks out of the confines of a trading range.

ISLAND REVERSAL (Cluster Gap)

Well we saved the best for last. The Island or Cluster Gap may be the most significant gap. It is most important at a major support or resistance level. The market sees the stock at a major bargain or very over bought. One more newsy gap in the direction gets very little follow through. The stock remains at the support of resistance level. Anxious to either catch the next rally or cash in at the first sign of trouble, another news item or rumor can spark a mad rush in a new direction. This signal is a strong one and it is rare enough that it is recognized as such and those who act on it often get great entry points on major trend reversals.

SUMMARY

Most stocks and indexes gap regularly but they are body gaps and fill during the day. While all gaps have significance, that significance can vary widely. The gaps of a stock that gaps frequently (even true gaps) are generally discounted and or ignored altogether. The hierarchy of gaps rides on the area that is gapped as well as how quickly it fills. A breakaway gap with no news, happening at a major pivot point like a 52 week high / low or an all time high / low would have to be considered a '10'. A reversal gap at the same locations would be a close second. Add the island or cluster characteristic to the reversal and you get a '10+'. Gaps tell you a lot about the sentiment of the traders and knowing how to interpret and weight them can only help you in your trading.

Now you have a good handle on gaps but a whole other subject is where gaps open and close and why. But that is another subject for another day.

Happy Trading!

Ryan Litchfield