Gap in a price chart is a void area where no buying or selling took action, just like between $17.60 and $18.50 in CSCO daily chart (down).
Gaps are caused by news that come out after the market close and are finally incorporated in stock’s price the next day that the market will be open. So, most likely they will be found on daily charts. Lets say that MSFT stock is closing today at $25. After the market close it announces profits that exceed greatly analysts’ expectations and that is changing the perception of market participants relatively to the value of the stock. Now MSFT value is at $27 but nobody can buy it because the market is closed. At tomorrow opening investors and traders are piling in to buy it and start negotiating near the new perceived MSFT price at $27 ( i.e. bid $26.83- ask $26.84). In this case we have a gap up. If the announcement was below analysts’ expectations we could have a gap down.
Classical technical analysis alleges that when a gap has opened it must be closed at some time and most of the times this is true, but not always and not in a fixed time horizon.
Generally we can classify gaps in 4 main divisions which are neither strictly defined nor easy to be detected in many cases.
A breakout gap occurs after the price has been in consolidation for some time (AAPL daily chart below). It is accompanied by great volume (2-3 times its three months average) and it takes much time before it closes, if ever. It signifies the continuation of an already existing trend or the beginning of a new one. The same is true for a breakdown gap but because the market tends to be much more time in an uptrend than in a downtrend, it is more possible that it will close.
It looks like the breakout gap. The only difference is that it signifies only the continuation of an already existing trend (without much consolidation). Everything that has to do with volume and the closing of the gap is the same as in breakout gaps (CMCSA daily chart below).
Exhaustion gaps are the final jump of the stock before it reverses its prior trend. Most of the times their volume is huge (2-6 times three months average) and they close very quickly (AKAM daily chart below).
Common gap is not a tradable gap and it doesn’t signifies anything. It can occur without any important fundamental or psychological reason (i.e. ex dividend days) and it is not very wide (XOM daily chart below).
In order to trade a gap first of all we must define support and resistance relative to the gap.
In a gap down the candlestick from where the gap started is a resistance zone consisted of trapped buyers who have great losses in less than 24 hours and are not just scared but terrified, (resistance zone 1, below). The gap down candlestick is also a resistance (resistance 2), because buyers who bought the stock immediately after the gap, (they believed it was cheap at this price), are trapped also. The three other categories that make the resistance property real are also get involved. Additionally, the bigger the volume on either of the gap edges, the strongest the resistance (more buyers trapped).
In a gap up the candlestick from where the gap started is a support zone consisted of buyers who have great profits in less than 24 hours and are more than satisfied, (support zone 1, below). The gap up candlestick is also a support (support 2) because market participants who bought the stock immediately after the gap up, (because they believed it was a nice opportunity), still buying whenever the stock revisits support 2 (they still believe it). The three other categories that make the support property real are also get involved. Additionally, the bigger the volume on either of the gap edges, the strongest the support (more satisfied buyers).