A price gap is an area on a chart where no trading activity has taken place. Imagine you're looking at a bar or candlestick chart, and you see a space where the price jumps from one level to another without any trades in between. This jump is called a gap.
Types of Price Gaps
There are three main types of price gaps:
- Gap Up: This happens when the low of the current candle is higher than the high of the previous candle. It's like the price suddenly jumped up overnight.
- Gap Down: This occurs when the high of the current candle is lower than the low of the previous candle. It's like the price took a sudden dive.
- Common Gap: These are usually small gaps that occur frequently and are often filled quickly. They can be caused by things like news events or earnings reports.
Why Do Prices Tend to Fill Gaps
Prices often tend to fill gaps because the market is trying to "correct" itself. When a gap forms, it creates an imbalance between supply and demand. When a gap occurs on a price chart, it's like the market has skipped a beat. This can be due to various reasons, such as unexpected news or significant earnings reports. Over time, the market often "corrects" this gap, a process known as gap filling.
For example, if a stock gaps up due to positive news, the price might rise quickly, but eventually, traders will start selling to take profits, bringing the price back down to fill the gap.
Traders often believe that prices will return to a "fair value" level. If a stock gaps up significantly, it might be seen as overbought, leading traders to sell and bring the price back down. Conversely, a gap down might be seen as an oversold opportunity, prompting buying. Gaps often create new support or resistance levels. For instance, a gap up creates a new support level at the previous high, and the price may pull back to test this level.If a stock gaps up, short-term traders might take profits, causing the price to fall back. Conversely, if a stock gaps down, bargain hunters might step in, causing the price to rise.
Imagine you're at a concert, and there's a sudden rush of people trying to get to the front row. The crowd creates a gap in the line, but eventually, people start filling in the space to get back to their original spots. Similarly, in the market, traders will buy or sell to fill the gap and restore balance.
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