There are three types of gaps in technical analysis namely – the breakaway, runaway (or measuring or continuation) and exhaustion gaps.
A breakaway gap is formed when the stock price breaks out at the completion of an important price pattern or sideways consolidation range. Breakaway gaps are of great interest to traders since they signal a potential change in trend. The formation of the gap highlights the bullishness or the bearishness of the breakout, depending upon the direction of the gap. A sideways consolidation is just a price range or band in which the stock or market has traded for a particular time period, a short-term. The upper boundary of the sideways consolidation acts as resistance, when the stock approaches from below while the lower boundary of the sideways consolidation acts as support when the stock approaches from the top. Market interest is required to break out of the sideways consolidation range.
The volume should pick up significantly during the breakout either up or down. Increased volume not only shows the high enthusiasm, it also means that those who are holding positions on the wrong side of the break out are squaring their position. The breakout point becomes the recent support, if the stock makes an upward breakout. Similarly, in a downward breakout, the point of breakout becomes the resistance level for the stock.
We would like to recollect one point about gaps which we had discussed in our previous techschool session. That is, generally the gaps get filled or closed because market dislikes vacuum. However, some gaps take quite some time to fill, it could be a day or a week or even a month. Hence, any trading strategies should not be executed on the belief that the gap would be filled or closed in the near future.
Refer to chart of Apollo Group (APOL) given below, which is listed on the Nasdaq. Following a downward gap in late March 2008, the stock found support at around $43 and consolidated sideways in a trading range of $43-$54 for almost three months. Triggered by the company’s Q3 earnings announcement which beat analyst’s expectation and hiking of the number of shares in the share buyback programme to $500 million during early July, the stock breakout of the range by forming a breakaway gap. Subsequently the stock began to trend up and encountered resistance at $68 in September.
Refer to the Brunswick Corp (BC) chart below representing a downward breakaway gap.