Another fundamental pattern that signals continuation is the “gap.” A gap occurs when the price of a stock during a given period is significantly higher or lower than the price range of that stock for the previous period. The price did not overlap at all over the two periods. This leaves what is known as a “gap” in the price chart. A “gap up” in the stock price is a show of strength. This tells us that the demand for the stock was so strong on the open that it jumped many points higher. The opposite is valid for a “gap down.” This signifies weakness as the stock gaps down usually due to aggressive selling.
The Breakaway Gap
The Breakaway Gap usually occurs when a stock is moving reasonably through a price range or channel, then the demand for the stock explodes, and the stock “gaps out” of the current trend. This is a sign of strength and a very bullish sign with a “gap up.” A breakaway gap to the downside is a sure sign of weakness.
The Continuation Gap
The Continuation Gap is another sign of strength, showing that demand is still strong, and the trend will continue; this often confirms the initial “breakaway gap.”
The Exhaustion Gap
The Exhaustion Gap can be the second or third gap and occurs during a powerful upsurge in price. This is a warning, as it might signify that the stock has overextended itself and may be due to a change in trend or a pullback. The opposite is true for an exhaustion gap on the downside, which might signal a bottom is near.
The Island Gap
The Island Gap occurs when demand is so high that price and the market participants drive the price up to unacceptable levels, and the demand dries up rapidly. This sudden oversupply causes the stock to plummet as all demand is satiated. Of course, too much supply with no demand causes falling prices.
Quick Tip: Gaps are important signs of serious shifts in supply and demand. If surges in demand outstrip the supply, prices rise to convince people on the sidelines to sell. Downside gaps indicate supply is outstripping demand, causing prices to fall.
This might seem all very theoretical, so here are gaps in action.
Gaps in action
Here we can see clearly how gaps can occur in stocks. STEC provides a perfect example of how understanding gaps is critical to trading success.