2.8 Gaps

Understand the different types of gaps, what each signals, and how to trade them (or avoid getting trapped by them).

Layer 2: Chart Literacy — Chapter 8 Goal: Understand the different types of gaps, what each signals, and how to trade them (or avoid getting trapped by them).

The Core Idea

A gap is a discontinuity in price where the open is significantly different from the previous close, leaving a visible "hole" on the chart. Gaps happen because the market closes for periods (overnight, weekends, holidays) but information continues to flow.

Gaps are some of the most reliably tradeable patterns because they reveal strong opinion by the market — enough that it couldn't wait for normal trading hours to reprice.

How Gaps Form

Overnight Gaps (Most Common)

Market closes at 4:00 PM ET
News breaks during after-hours (earnings, M&A, FDA decisions)
After-hours trading reprices the stock
Next morning opens at the new price → gap

Weekend Gaps

Friday close to Monday open
News over the weekend (geopolitical events, regulatory news)
Larger time window → potentially larger gaps

Pre-Market Gaps

Pre-market activity (4 AM - 9:30 AM ET) sets the open price
News before market open creates the gap

Intraday Gaps (Rare)

Halt and reopen creates a mini-gap
Mostly limited to halted stocks

The Four Types of Gaps

This is the framework every trader should know.

1. Common Gap

Looks like:

Small gap (typically <2%)
In a sideways or range-bound stock
Low volume
Quickly fills (price returns to the pre-gap level)

Meaning:

No real news or significance
Just normal market noise

Trade: Gap fill trades. Bet that the gap will fill within a few days. Works ~70% of the time on common gaps in ranging stocks.

2. Breakaway Gap

Looks like:

Large gap (often 3%+) out of a consolidation pattern
High volume on the gap day
At the start of a new trend
Doesn't fill (or only partially)

Meaning:

Genuine new information has shifted the stock's valuation
The market has "decided" the stock is worth a new range
Often the start of a significant trend

Examples:

Earnings beat + raised guidance
FDA approval
Major contract win
Buyout announcement

Trade: Trade WITH the gap direction. Don't try to fade it. Best entry: pullback to the broken level (which now acts as support/resistance).

3. Runaway / Measuring Gap

Looks like:

Mid-trend gap
Confirms the trend's strength
Volume confirms

Meaning:

The trend is accelerating
Often occurs at the midpoint of a major move
Useful as a "measurement" — the move from start to runaway gap often equals the move from runaway gap to end

Trade: Trend continuation. Hold existing positions; don't chase if you missed.

4. Exhaustion Gap

Looks like:

Gap at the END of an extended trend
Often very large
Quickly reverses
High volume that fades

Meaning:

Last buyers (or sellers) capitulating into the trend
"Final shakeout" before reversal
Hard to identify in real time — usually only clear in hindsight

Trade: Counter-trend if confirmed by reversal signals. But this is the hardest to identify — often only the second day reveals which type of gap it was.

Telling Gap Types Apart

This is where it gets tricky. Here's the practical framework:

Use Volume + Context

Type	Volume	Context	Behavior
Common	Low	Sideways stock	Fills quickly
Breakaway	High	After consolidation, at major level	Doesn't fill, starts new trend
Runaway	High	Mid-trend	Doesn't fill, trend continues
Exhaustion	Very high	After extended trend	Quickly reverses

Practical Tells

Breakaway gap: From a range, with catalyst, on big volume. Stock holds the new range over multiple days.
Runaway gap: Already in a trend, no specific catalyst needed, mid-move.
Exhaustion gap: Trend has been running for weeks/months, climactic volume, fast reversal within 1-3 days.

"Gap Fill" — The Most Common Gap Strategy

The Mechanic

Markets have a natural tendency to "fill" gaps — i.e., price returns to the pre-gap level.

Why It Happens

Liquidity at the gap level was skipped — there's "unfinished business"
Algorithms target unfilled gaps as price levels
Retail uses gap fill as a known reference

How Often Gaps Fill

Common gaps: ~70-80% fill within a few days
Breakaway gaps: ~30-40% fill (the rest don't)
Runaway gaps: ~20-30% fill
Exhaustion gaps: ~70%+ fill (because they reverse)

Trading Gap Fills

Risky strategy unless you correctly identify the gap type. A gap fill bet that becomes a breakaway gap = catastrophic losses.

Better approach: Only fade gaps that look like common gaps (small, no news, low volume, in a ranging stock).

Gap and Go vs. Gap and Fade

These are common intraday patterns.

Gap and Go

Stock gaps significantly
Continues in the gap direction throughout the day
Often happens with breakaway or runaway gaps
Strong volume sustains the move

Gap and Fade

Stock gaps
Reverses during the day
Often happens with common gaps or exhaustion gaps
Volume fades after the open

For day traders: This is a daily decision. Is today a gap-and-go or gap-and-fade?

For swing traders: Pay attention to the FIRST 30 minutes after the open. If price holds the gap, expect a gap-and-go. If it starts reversing aggressively, expect a fade.

Earnings Gaps (Special Case)

The Mechanic

Most companies report quarterly earnings after the close or before the open. The stock often gaps significantly the next day.

Direction

Beat + raise → typical gap up
Beat + maintain → mild gap up or flat
Miss → significant gap down
Beat + lower guidance → often gap down despite the beat

The Initial Reaction Lies

Often the initial gap reaction is wrong — the stock reverses during the day or week as the market digests the full earnings call.

PEAD (Post-Earnings Announcement Drift)

After the initial reaction settles, stocks that beat tend to drift further in the gap direction over 30-60 days. This is one of the most documented anomalies in finance.

For swing traders: the drift, not the initial pop, is where the edge is.

How to Trade Gaps as a Swing Trader

Strategy 1: Trade WITH Breakaway Gaps (PEAD)

Stock gaps up on earnings beat
Wait 1-3 days for the initial reaction to settle
Confirm gap holds (no immediate fill)
Enter long with stop below the post-gap low
Hold for 30-60 days targeting continuation

Strategy 2: Pullback to Gap

After a breakaway gap, wait for a pullback to the upper edge of the gap
The gap edge often acts as support
Enter long on bounce confirmation
Stop below the gap

Strategy 3: Avoid Gap Fills (Mostly)

Unless you're certain it's a common gap, don't bet on a fill
The risk is asymmetric: if it's actually a breakaway gap, you're in big trouble

Strategy 4: Pre-Market Range

Note the pre-market high and low
If the stock breaks pre-market high after the open → bullish
If it breaks pre-market low → bearish
Use these as entry/stop levels

If you risk 1% per trade with normal stops
But a stock can gap 20% overnight
Then on stocks with gap risk, reduce your position size
Or skip overnight holds before earnings

Identifying Gaps in Your Watchlist

Daily Pre-Market Scan

Check overnight news on your watchlist stocks
Note any pre-market moves of >3%
Identify if there's a catalyst (earnings, news)
Categorize the likely gap type (common, breakaway, exhaustion)

Useful Tools

Finviz "Top Gainers" / "Top Losers" — pre-market and intraday
Benzinga Pro — real-time news catalysts
Earnings calendars (Earnings Whispers, EarningsHub)
Your broker's pre-market scanner

A Mental Model

Think of gaps as fault lines in the chart:

Small fault lines (common gaps) often heal quickly
Major fault lines (breakaway gaps) restructure the landscape
The market has "decided" the old terrain isn't relevant anymore
Pretending the old level still matters = ignoring an earthquake

When a stock gaps significantly with volume and news, don't fight it. The world has changed for that stock.

Practical Takeaways

Four types of gaps: common, breakaway, runaway, exhaustion. Each has different implications.
Volume + context is how you tell them apart.
Gap fills work on common gaps, fail dangerously on breakaway gaps.
PEAD is real and tradeable — drift after earnings, not just the initial pop.
Stops don't protect against gaps. Position sizing does.
Avoid holding through earnings unless you specifically want PEAD exposure.
Pre-market activity is information — note pre-market highs/lows.

Quick Self-Check

Before moving to 2.9, you should be able to answer:

What is a gap and what causes it?
Name the four types of gaps and their key differences.
What is the difference between a breakaway gap and an exhaustion gap?
What is the "gap fill" strategy and when does it work?
What is PEAD and how do swing traders use it?
Why don't stop losses protect against overnight gaps?
When should you reduce position size for swing trades?

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