Thread by @gautam_icma

Theory of Gaps (A thread)

Gaps in technical charts are formed because of news flow after the market has closed and before it has opened. It is a no trading zone.

A common myth associated with gap is that it is always filled. Waiting for gap to be filled can at time prove too costly for a trader.

Sensex had registered a gap from 12219 to 13479 ways back in the year 2009 which remains unfilled till date.

Types of Gap

Area or Common gap

Breakout gap

Runaway gap or Measuring gap

Exhaustion gap.

Area or Common gap

These are generally seen in illiquid stocks. It has no bearing on its trend.

Gaps might be created if a stock becomes ex-dividend, or ex split. These types of gaps should be adjusted by analyst before studying them.

Breakout gap
This is one of my favorite. If spotted at the correct time one can use it to trade on an intermediate term time frame. The volume in such cases is generally on higher side a short covering as well as fresh buying comes in.

The gap is associated with a trend change on an intermediate term time frame.

When a breakout gap takes place after long period of trading range, generally a fast move is associated with it.

Runaway gap or measuring gap

This type of gap generally occurs in middle of a strong trend. It is a signal of trend intensifying.

Psychology behind runaway gap is missed out traders jump into the bandwagon as sudden major fundamental news changes the rating of the stock.

Volume is generally average or slightly higher on the gap day and it increases after wards.

A measuring aspect can be attached to the gap and hence often called measuring gap.

Exhaustion gap.

This gap generally occurs at top or bottom of the trend. Euphoria / pessimism are generally high and such volume can be very high. Trading volume diminishing after the gap day is usually first warning sign that an exhaustion gap may have formed.

The gap is filled in generally a short time frame. The price thereafter moves in opposite direction to which the gap was created. In many cases it marks the end of trend.

Island Reversal

It is a combination of exhaustion gap followed by breakout gap. A sort of island can be identified from bars of certain number of days.

It is a very strong patter and has potential to reverse the trend significantly (intermediate trend) and sometimes even entirely (Primary trend).

Series of Gaps (usually seen in indices)

An uptrend resumes after a prolonged down trend of more than five to six months. The uptrend registers a series of gaps at regular interval. It is a signal of a strong bull market ahead. Dips should be used to buy.

At the top end of the market when valuations are generally high, all of a sudden a breakout gap takes place and price moves up.
A series of gaps is registered in short time frame. Gaps are accompanied by a parabolic rise in index/ stocks.

A significant mean deviation takes place from short term averages. It should be taken as a warning sign. A major top is likely to take place is near future. One should watch out for reversal signals from price.

Caution:
1.Creation of gaps results in volatility. Stop loss in trade might be deep.
2.Points discussed above have a success rate of 80%, but draw down on losing days are high. Careful planning is must to negotiate days which creates gaps.

3. Intraday charts with 30 min and 60 min time frame often helps in such cases.
4.Blindly following measuring aspect may hurt a trader.

The End.