A gap occurs when the range of prices for a day is completely outside the range of the previous day. Gaps primarily reflect a change of attitude toward the market by traders. Usually, some fundamental news has dramatically changed the direction of the market from market closing one day to the opening of the next day.
The following examples should help to illustrate some common types of gaps.
Figure 1 Gaps Caused by Foreign Market Trading.
The market doesn’t like gaps, and most of the time, it will eventually come back to fill the gap.
Figure 2 The British Pound traded locally in Chicago.
Keep in mind the impact of worldwide interest in a market. Notice how many gaps there are in the Chicago chart.
Figure 3 Globex British Pound, traded around the world 23.5 hours a day.
You can see in this chart that most of the gaps are absent. The gaps on the Chicago chart were made while we were sleeping. Night trading has changed the nature of trading since our world has become computerized. (No rest for the weary trader!)
Breakaway Gaps occur when a market “breaks away” from congestion. Generally, the upward move is dynamic, because traders with short positions are scrambling to get out of the market.
Exhaustion Gaps happen near the end of a move and signal the last effort of the market. This gap is generally followed by two or three days of market trading inside the range of that day, creating the look of an island. If the market trend reverses and trades outside the range of the gap, it is wise to trade with the reversal trend after it has been confirmed.
A Midway Gap occurs when the market has been trending for several periods, followed by three to five periods of consolidation. Following the consolidation, there is a gap in the direction of the trend. This is sometimes referred to as a measuring gap.
Figure 7 Island Top
No, we’re not talking about bikinis, here. An island formation is probably the least common type found on charts. In order to be an island, there must be a price gap on both the left and right sides of the island. This type of activity can occur on just one day or over the span of several days. The wider the gap, the greater is the likelihood that it is indeed a signal. This is the same type of chart pattern as a gap, and should be treated as such.