Chapter 1: Gaps - Technical Analysis

What are Gaps?

Gaps represent an area on the chart where the price of the stock moves swiftly either up or down with no trading activity in between. Gaps are witnessed when there is frantic buying or selling in the markets.

It can be witnessed on the chart in any timeframe but is more commonly found on the daily chart. This is because traders digest the information obtained after market hours and tend to act upon it at the start of the next trading session.

Another reason is that gap on a weekly chart can fall only between Friday’s price range and Monday’s price range and even more rarely in the monthly time frame.

On which chart types are gaps observed?

Gaps can only be observed on the candlestick chart or the bar chart. A technical analyst making use of a line chart would not be able to spot a gap as all the points tend to be connected.

For e.g. Gap can be witnessed on a Nifty candlestick chart

For e.g. Gap cannot be noticed on a Nifty line chart

 

Gap direction: Upside Gap

Gaps can be witnessed in either of the two directions:

Upside gap: Upside gap is witnessed when the lowest price of a specific trading period is above the highest level of the previous trading period.

For e.g., Let us consider that a stock closed at Rs.1,000 on day 1 and opened at Rs.1,050 on day 2. This jump in price from 1,000 to 1,050 is termed as a gap up opening. There are several reasons for this gap up opening. One common reason is the announcement of positive financial results of the company. The upside gap signifies a very strong bullish sentiment.

In the above chart, we witness a gap up opening; Andhra Bank’s stock closes at Rs58.8 on October 24, 2017, and opens at Rs64.35 the next day. This gap up opening was witnessed on account of the bank recapitalization program, which the government announced for PSU banks.

Gap direction: downside Gap

Downside gap: Downside gap is observed when the highest price for a specific trading period is below the lowest price of the previous trading period.

For e.g., If a stock closed at Rs1,000 on day 1 and opened at Rs950 on day 2, it is termed as a gap down opening. Gap down opening signifies a strong bearish sentiment.

In the above chart, Nifty closed at 10,760 on February 2, 2018, and opened at 10,604 in the next trading session, witnessing a gap down opening of 156 points. The gap down opening was witnessed on account of a selloff in global markets.

Do all gaps get filled?

It is observed that most gaps are eventually filled, but it is not always the case. However, we cannot explicitly ascertain a fixed time duration within which a gap gets filled.

Thousands of gaps are created in different stocks with some of them never getting filled; hence, it would not be appropriate to base trading strategies purely on the assumption that the gap will be filled in the immediate future.

Example

An example of a gap getting filled immediately can be seen in the chart below.

In the above example of Lakshmi Vilas Bank, the upward gap got filled within three trading sessions.

Another example of a gap not getting filled for years can also be seen below.

In the above chart, the bullish gap in CCL Products was formed in 2016 and has still not been filled. There is a good chance that this upward gap may not be filled for a few more years.

Gaps that do not mean much

It is important to avoid giving weightage to gaps that do not carry much technical significance.

a) Illiquid securities which form numerous gaps on a regular basis do not signify that anything special has occurred. Due to low liquidity, such stocks easily tend to hit exchange-set circuit limits while the bid/ask quotes tend to a have wide spread, which results in these frequent gaps.

Penny stocks that tend to witness gaps on the chart due to low liquidity do not carry much technical significance either, as is the case in the above chart of Stampede Capital, which witnessed a gap up opening almost on a daily basis.

b) Options charts also tend to show wide gaps. Gaps occur due to two reasons on option premium charts: (i) decay in time value, and (ii) low liquidity in most options that are traded.

Below is an example of an option premium chart:

c) Gaps that appear on the chart when a stock goes ex-dividend or gives bonus possess no trend implication. These are gaps created due to corporate actions and not due to a change in supply-demand relation that governs the trend. Most advanced charting softwares provide the option to adjust the chart for dividend and bonus gaps.

In the above chart of Coal India Ltd (CIL), we witness a gap down opening due to the company going ex-dividend. CIL announced a dividend of Rs18.75 and went ex-dividend on March 14, 2017, witnessing a gap down opening of nearly the same amount.