It was another challenging day for stocks as popular stock market indexes fell from -2.79% to 4.68% on fears of accelerating inflation and concerns about Wednesday’s FOMC meeting. Interestingly, major stock indexes recorded second gap-downs after experiencing gap-downs last Friday (6/10/22).
Gaps are the space between opening and closing prices for two consecutive days. There are bullish gap-ups or bearish gap-downs. Some gaps are filled, while others are not. It depends on the type of gaps and the market conditions.
Typically, there are four types of gaps - common, breakaway, continuation or runaway, and exhaustion gaps. Gaps provide insights into the various stages of a rally (uptrend) and decline (downtrend).
Although gaps are easily recognizable on the charts, it is much harder to pinpoint the exact type of gap. Understanding the characteristics gap patterns can help an investor or trader better determine the extent of the rally or decline and an impending reversal.
A common gap is the most frequent type of gap pattern. It occurs during normal trading and is not significant in its price actions. The size of the gap is minor in size to the other gaps. It is typical to show normal-to-low volume. Common gaps can be news or event generated, including ex-dividend, new share issues, and the expiration of futures contracts. As a rule, avoid trading common gaps without a strong trend. Since the gaps often do not produce new highs or lows, the gaps are filled soon after the formation.
A breakaway gap often develops toward the end of a price pattern, typically with a price breakout to the upside or a price breakdown to the downside. The action signals the start of a new trend or a change in the direction of the primary trend. A breakaway gap accompanied by heavy volume often occurs during the breakout of a trading range. An upside breakout triggers a series of new highs, and a downside breakdown leads to new lows. A breakaway gap is not normally closed.
A continuation/runaway gap typically occurs with one or more gaps within an existing primary trend. The gap occurs during solid bull or bear trends and signals a significant price move in the direction of the prevailing trend. Important market news, economic news, or events can lead to runaway gaps. The gaps are not closed immediately. It will require time before filling the gaps.
An exhaustion gap is the opposite of a breakaway gap, signaling the reversal of bull or bear patterns and trends. An exhaustion gap signals the final move of a price pattern or the last surge before the end of a trend. Volume is always heavy. The gap alerts a trader to prepare for a trend reversal. It differs from a continuation gap as there are no new highs in an uptrend or new lows in a down-trend. The gap is closed shortly afterward.
If you side with the bulls, you hope that the two consecutive gap-downs are exhaustion gaps, signaling the bear decline is nearing an end. On the other hand, if you side with the bears then you hope for a continuation or runaway gap as this reinforces the sustainability of the prevailing downtrend.
We are neither bulls nor bears but realists. A realist accepts the situation as it is and is willing to deal with it accordingly.
Unfortunately, the two consecutive gap-downs from 6/10 and 6/13/22 appear to resemble runaway gaps. If the two gaps are not immediately closed, this further reaffirms additional selling before a sustainable market bottom.