Volatile markets can lead to gaps on the charts as they are more common than expected. Gaps are spaces on the charts where the price of a security moves sharply higher or lower, with little or no trading within a short timeframe. Gaps tend to develop quickly to reflect the changes in the perceived value of the security due to abrupt changes to fundamental, macro, or technical conditions.
For instance, a gap-up can develop when a company's earnings release is much higher than expected. The stock price can suddenly open sharply higher with a gap-up or an upside space on the chart. Another example would be an unexpected takeover or merger news announcement. A stock that breaks out of a significant technical basing pattern can also create a gap-up on the chart. On the other hand, a gap-down can develop on a major technical breakdown or an adverse earnings release that misses expectations by a wide margin.
Opportunistic traders and investors can take advantage of these technical patterns by identifying the type of gaps and when the gaps occur within the primary price trend. There are four types of gaps: breakaway, exhaustion, common, or continuation (also referred to as runaway).
Breakaway gaps often occur at the end of a price pattern, signaling a new trend.
Exhaustion gaps occur near the end of a price pattern, warning at one final attempt to hit new highs or lows. Common gaps cannot be placed within the timeline of a price pattern as they are common occurrences in the area where the price has gapped up or down. Continuation gaps or runaway gaps occur in the middle of a price pattern, suggesting a lot of buyers or sellers suddenly entering (buying) or exiting (selling) the security.
The question as to whether a gap is filled remains a controversial subject where it is open to numerous interpretations. When someone says a gap is filled, this means the price has moved back to the original price level before the gap-up or gap-down. Gaps are often filled if the following conditions:
(1) The gap occurs due to overly optimistic (i.e., irrational exuberance) or pessimistic (i.e., panic sell-off) views, resulting in a counter-trend correction or a rally.
(2) A gap-up or gap-down that develops above key technical resistance and below a key breakdown that does not have any other support or resistance levels can lead to gaps quickly being filled.
(3) The specific price patterns that accompany the type of gaps can often help to determine if a gap is closed or not.
(4) Exhaustion gaps are always filled as they signal the end of a price trend and the start of a reversal.
(5) Continuation and breakaway gaps do not need to be closed because they confirm the direction of the current primary trend.
Here is the summary of the gaps. Once a stock fills the gap in question, it will rarely stop unless the gap level offers significant immediate support or resistance. Exhaustion gaps and continuation gaps are dependable in forecasting the direction of the primary trend. However, recognize that these types of gaps tend to predict the price moving in two opposite directions. So, traders and investors must determine the specific type of gaps before executing the trade.
The herding mentality of retail investors can lead to speculative trading, irrational exuberance, and panic-type selling behaviors. Institutional investors typically do not participate in speculative or panic behaviors. However, if they are behind in performance near the end of the month, quarter, or year-end, they tend to chase performance in a desperate attempt to catch up, escalating the extreme price movement.
Irrational exuberance is not necessarily immediately corrected by the market. Sometimes, stocks and markets can rise for many years at extremely high valuations with unbelievable price momentum without sustaining a correction. Traders and investors who can identify the specific gaps and ensuing technical patterns can increase the probability of a successful trade or investment.
It is rare to witness more than one gap in a month within a key US market index. So far this month, there have been five unprecedented daily gap-ups in S&P 500 Index, including 10/7, 10/14, 10/15, 10/19, and 10/20/21.
So, will these gap-ups be filled?
Unless the October gap-ups in the SPX Index are continuation or breakaway gaps, you can expect some of the recent SPX gap-ups to be closed. The recent SPX rally that began on 10/13/21 recorded four gap-ups within a 5-day window. Three of the gap-ups have converged near potentially significant technical support zones. Remember, support levels take on more significance when the technical conditions convergences near the same levels.
The 10/19/21 gap-up at 4,488.75-4,496.41 could be critical support as it corresponds to the breakout above the left and right shoulders of a head and shoulders top pattern at 4,480.26 (8/16/21 high or left shoulder) and 4,465.40 (9/23/21 high or right shoulder), respectively. This level turns into key initial trading support on pullbacks.
The 10/15/21 gap-up (4,439.73-4,447.69) also coincides with a technical breakout condition, thereby negating a lower-high pattern (4,429.97). Also, the 50-day ma is now at 4,441.73 providing pivotal support. Failure to find support here warns of a return to 4,372.87-4,386.75 (10/14/21 gap-up) and 4,365.57-4,383.73 (10/17/21 gap-up), corresponding with an island reversal formation.