Mind the Gap: Understanding the 3 Types of Price Gaps

What is a Gap Up?

A gap up in the equity market alludes to an instance where a stock opens the trading session higher than its closing price the previous session. The “gap” refers to the empty space on the daily timeframe that is illustrated on the chart between the open and the previous day’s closing price. Bullish price gaps usually occur due to positive news, such as a strong earnings report or a new contract offer. Soccer franchise owner Manchester United MANU is an excellent example of this phenomenon. In the last few months, the stock gapped up three times on news that it was putting itself up for sale and received potential offers from several investors.

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With all else being equal, investors generally view gap ups as a bullish development, demonstrating demand for shares outside of market hours.

Gaps can be the Precursor to Major Advances

The stock market can be counterintuitive, especially when compared to the outside world. For example, when a consumer shops, they often look for a bargain and try to pay a lower price. Conversely, in the stock market, a gap higher in price may lead to even higher prices.

In May of 2013, shares of Tesla TSLA gapped higher by 16% to a split-adjusted $47 a share. While many amateur investors likely thought the price was “too high”, the gap up was just the start. By February 2014, Tesla shares had climbed to over $260!

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In May 2020, shares of enterprise software company Twilio TWLO catapulted higher by 39.62% to $170 a share on volume turnover seven times the norm. Fast forward six months, and the stock traded at over $400 a share.

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Image Source: Zacks Investment Research

All Gap Ups are not Created Equally

Of course, not all gap-ups end up producing the results that Twilio and Tesla did. For this reason, it is imperative that investors recognize that all gaps are not created equal. Three types of gaps exist:

Common Gap:  As the name implies, common gaps occur more than any other type of gap. Common gaps are small (typically between 1-3%) and are most prevalent in the stock indexes (but can be found in all stocks). Almost always, these types of gaps tend to be sold into, resulting in a gap fill. “Gap fill” means the instrument trades back to the pre-gap area. (i.e if a stock gaps from $10 to $11, then back to $10). Earlier this week, the Nasdaq 100 ETF QQQ produced a common gap.

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Because common gaps tend to get filled within days, investors should avoid buying them.

Exhaustion Gap: An exhaustion gap tends to occur after a stock has already had a massive move higher and is extended in price. This type of gap is typically very large and has a high-volume signature (points to churning of shares). In January 2021, GameStop GME gapped higher by 134% to $120 a share. The exhaustion gap marked the top, and shares have fallen back to $20 currently.

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Image Source: Zacks Investment Research

The exhaustion gap came after the stock had run from $4 to $40 in a two-month period and marked the top in the stock. Savvy investors use exhaustion gaps to sell into strength - knowing they often get filled. The critical point to remember is that exhaustion gaps occur after a large run, and multiple large gaps can signify a climactic topping pattern.

Breakaway Gap: A breakaway gap occurs at the beginning of a move when a stock gaps above prior resistance – usually on positive news such as a better-than-anticipated earnings report. Biotech giant Gilead Sciences GILD is a recent example of a breakaway gap. For more than a year, the stock had been range bound. However, in late October, the company reported strong earnings and gapped strongly above resistance on volume double the norm.

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Because breakaway gaps tend to occur at the beginning of a move and tend to not get filled, they are the only type of gap that should be purchased. Investors should note that the best breakaway gaps tend to close near the high of the daily range. A poor close can hint that the gap may be prone to failure.

 

Summary

Some of the biggest winning stocks of all time have started their massive price advances with bullish breakaway gaps, including Meta, Alphabet GOOGL, and Tesla. Savvy investors realize the difference between common, breakaway, and exhaustion gaps. History teaches us that rather than being scared of “chasing” gaps, we should embrace them and learn to identify those with potential. Good news, high volume, and a strong closing range increase the odds of success. While it is not always easy to spot the difference between the types of gaps, investors can gain confidence by using the change date feature on their charting service to study and learn from historical precedents. Though history does not always repeat itself, it does tend to rhyme.

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Gilead Sciences, Inc. (GILD) : Free Stock Analysis Report

GameStop Corp. (GME) : Free Stock Analysis Report

Tesla, Inc. (TSLA) : Free Stock Analysis Report

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Manchester United Ltd. (MANU) : Free Stock Analysis Report

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Twilio Inc. (TWLO) : Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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