A gap is a break in the price chart of a security, which occurs when the price suddenly rises or falls sharply, causing certain price levels to be skipped so that no trading takes place at those levels. This results in a "gap" on the price chart, where the price bars initially do not overlap as in normal trading.
Gaps can occur for a variety of reasons, including the announcement of important news or information, whether or not directly related to the stock in which the gap occurs. More commonly, a change in underlying market sentiment can also cause gaps to occur in indexes, ETFs or individual stocks.
Whatever the reason, gaps arise because there is a sudden sharp increase in trading that causes the price of a security to rise or fall rapidly, resulting in a gap.
A gap up is when the price suddenly rises extremely, this is a bullish scenario. A gap down is bearish and occurs when the price suddenly opens noticeably lower than the previous close on the price bar.
Four main types can be distinguished; the regular, breakaway, runaway and exhaustion gap.
We already know that a gap is nothing but a change in the price level between the close and the opening of two consecutive days (or hours/minutes if you are using intraday charts).
Full gaps are considered to be stronger and thus more relevant than partial gaps. Full gaps usually occur when there is strong upward momentum.
Traders can use gaps in their technical analysis to identify potential trading opportunities or as warning signals to protect or even close open positions. For example, a trader who sees a breakaway gap on the price chart of a security may consider taking a long position (i.e., buying the security) on the assumption that he may be dealing with a new uptrend. The breakaway gap usually allows a short stoploss to be placed.
On the other hand, a trader who sees a runaway gap on the price chart of a security can take advantage of the momentum and maintain or even extend the current long position, speculating on the continuation of the existing uptrend.
Gaps that manifest themselves after a strong trend are possibly exhaustion gaps, which are the harbinger of an imminent top or bottom. These are warning signals. When an exhaustion gap is filled it is a signal for traders to close existing open positions in the direction of the existing trend or at least raise the stoploss.
In our stock screener, you can easily use a filter to detect bullish or bearish gaps that occurred during the past trading day. More information in this article: "Finding Gap Stocks with the Stock Screener"