Stock Market Gaps: Meaning, Types, and Trading Strategies

Stock market gaps are a common phenomenon that you may encounter when investing in the capital market. They represent sudden jumps or drops in a stock’s price between two consecutive trading periods, leaving a gap on the price chart. 

Understanding these gaps, why they occur, and how to trade around them can provide valuable insights into market sentiment. With this knowledge, you can also formulate effective trading strategies. 

A stock market gap occurs when the price of a stock opens significantly higher or lower than its previous closing price, with no trading activity in between to bridge the price difference. On a price chart, this appears as a blank space or ‘gap’ between two candlesticks or bars. 

Gaps can happen in any timeframe—daily, weekly, or intraday—depending on when the market opens relative to the last traded price.

Stock market experts classify gaps into four main categories based on their context and significance. Check their details below:

1. Common Gaps

• Description: Also called area or trading gaps, these gaps occur without any significant news or fundamental reason. They are a typical part of normal price fluctuations within a trading range or consolidation phase.
  

• Characteristics: Usually small in size and are filled (closed) quickly as price returns to the gap zone.
  

• Significance: Generally, they do not signal a change in trend but indicate temporary pauses in trading activity.
  

2. Breakaway Gaps

• Description: These occur at the end of a price pattern, such as consolidation or chart patterns (like triangles), and signal the start of a new trend, either bullish or bearish.
  

• Characteristics: Accompanied by high trading volume, indicating strong market conviction.
  

• Significance: Breakaway gaps are important trend indicators and often mark significant price moves.
  

3. Runaway (Continuation) Gaps

• Description: Appear during an ongoing trend, indicating a strong continuation of the current movement.
  

• Characteristics: Volume remains relatively high but less than breakaway gaps.
  

• Significance: Confirms that the existing trend has momentum and is likely to continue.
  

4. Exhaustion Gaps

• Description: Occurs near the end of a significant price move and often signals a possible reversal or slowing of the trend.
  

• Characteristics: Large gaps followed by sharp reversals or declines in volume.
  

• Significance: Important to spot trend exhaustion and to prepare for potential reversals.

Several strategies help you capitalise on gaps, each with unique entry and exit criteria. Some of these are as follows:

1. Gap and Go Strategy

• Concept: You buy a stock immediately after a gap up, riding the momentum to profit from continued upward movement
  

• Key factors: Confirmation of high volume, strong market conditions, and quick execution are crucial
  

2. Gap Fill Strategy

• Concept: You look for reversals to the gap zone for potential entries by betting on the price moving back to fill the gap area
  

• Rationale: Many gaps tend to be filled as market participants realise the price overshot or corrections happen
  

3. Fade the Gap

• Concept: A contrarian approach where you bet against the gap direction, expecting a reversal soon after the gap forms
  

• Risk: This strategy requires careful risk management due to the volatility and unpredictability surrounding gaps

Gaps arise due to the difference in price expectations and market conditions between the close of one trading session and the opening of the next. The causes of gaps include the following:

• Earnings Announcements: Positive or negative earnings surprises often lead to gaps as investors react to the new information.
  

• Corporate News: Mergers, acquisitions, management changes, or product launches can cause sudden price changes.
  

• Economic Data Releases: Macroeconomic reports like inflation, GDP, or employment figures impact market sentiment broadly.
  

• Geopolitical Events: Political instability, policy changes, or global events influence stock prices and create gaps.
  

• Market Sentiment: Overwhelming buying or selling pressure outside trading hours can cause gaps when the market opens.
  

Since markets are closed after hours, any new information or changing sentiment accumulates. This results in a price jump or drop at the opening of the next session.

Stock market gaps are visually identifiable on price charts as spaces where no trading took place. Traders use candlesticks, bars, or line charts to spot these gaps easily. Here are some of the points to interpret gaps:

• Size of the Gap: Larger gaps usually indicate a stronger market reaction

• Volume During the Gap: High volume supports the validity of the gap as a meaningful move

• Gap Fill: Often, prices return to ‘fill’ the gap area, retracing the gap movement partially or fully

• Location: The gap’s position within a trend or consolidation phase helps determine its significance

While potentially lucrative, gap trading carries a distinct set of risks. Here are a few factors to consider:

• Volatility: Gaps often come with sharp price swings that can quickly trigger stop-loss orders
  

• False Signals: Not all gaps signal strong trends; some may be false breakouts
  

• Volume Confirmation: Lack of accompanying volume can reduce the reliability of gap signals
  

• Market Conditions: Gaps in illiquid stocks or during low-volume sessions may not follow typical patterns
  

Combine gap analysis with sound risk management and complementary indicators before you take action. 

Stock market gaps are powerful signals embedded in price charts that reveal sudden shifts in market psychology and supply-demand dynamics. Understanding them and practical trading strategies related to them can help you better navigate price movements. Make sure to carefully analyse the gaps, volume, and risk to make smart moves.

This content is for educational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.