Gaps are well-known to experienced traders. They are spots on a chart in which the price of an instrument jumps up or down from the current trend, creating a hole, or a gap, between trading periods. Gaps typically occur when buy and sell orders are placed prior to the day’s opening, causing starting prices to shift upward or downward to such an extent that there is no overlap between the candlesticks at the end of consecutive trading days. The impetus for such accelerated activity can stem from a host of technical or fundamental changes during the off-hours.

Gap ups and gap downs are very common in most market with the exception of foreign exchange, or forex, where they are extremely rare. Perhaps more common are gaps on the opening price where price later retraces to intersect with the previous day’s activity.

For example, if Stock A closes at 15.000 on the first day and opens at 13.000 on day two. Price may then surge upward for the remainder of the day, closing above the previous day’s close of 15.000. Many traders would call this a “gap down on the open” but not a full gap down as the market retraced the gap and filled it on the same day via a higher closing price. A stock can also gap up on the open in the event price opens higher than the previous day’s close.

There cannot be a gap down on the close because gaps are determined by the opening price of the most recent trading day. Additionally, some traders discount the overlap of upper and lower shadows when qualifying gaps, allowing for shadows that extend into the real bodies of the preceding candlestick so long as the bodies themselves evidence a gap.

When a gap “fills”, this means that price activity has returned to the level in which the gap formed. Most gaps, known as short-term gaps, fill within a few days of forming, while others may require weeks or even months, also known as long-term gaps. Considering that most gaps are of the common variety, the holes in between close and open are usually not very significant and thus quite easy to fill within a few trading periods.

Depending on who is asked, some traders and analysts will insist that all gaps in the market, no matter how big or small, will eventually fill up. Others claim that certain gaps will never fill or that there is no rule stating they must. These analysts point to gaps that have been gone unfilled for several years as proof of this phenomena. Which side is right?

In truth, both are correct, technically speaking. The vast majority of gaps will, in fact, fill over time, whether right away or several years down the road. Requiring several years for a gap to fill does not mean it will never be filled, however slim the chances of doing so appear as time wears on.

It is also quite possible, however, that certain gaps will never fill. One scenario in which this might occur is if a stock experiences a severe drop in price and never recovers before an acquisition occurs or the company goes out of business. Likewise, if the company’s fundamentals change and the price is reflected in a steep drop, the company may never be able to adapt and bring more buyers into the market again.

The chart below highlights an example of how frequently a market can produce gaps, including extreme ones.

 

The company is Macarthur Coal Limited (MCC.AX), and for nearly the past two years it has manifested several extreme gaps up and down. All but two gaps have filled by subsequent price activity, including the gap up and gap down in March and April of 2010 when price traded within the same ranges over a year later in August 2011.

 

The market has been extremely volatile for MCC, a volatility reflected by more than large gaps. Wild fluctuations in price have taken place, primarily between 10.166 and 14.000, but also peaking above 16.680 and dipping to almost 9.250.

 

In July 2011, the stock manifested its most extreme gap yet by gapping up from around 11.500 to over 15.000. Price dipped slightly in August, but not nearly enough to fill the hole. Most interesting to note is the consolidation that has taken place in the wake of the gap, with price trading within extremely tight corridors. Currently, MCC is trading within its smallest range yet as it repeatedly tests support at 16.210.

 

As previously mentioned, it is possible that the July gap will never be filled and that MCC will continue to trade above it. But recent signs of consolidation indicate the stock is ready to break out, and based on its history of failing to break through higher levels of resistance, the odds tend to favour a bear market. How long the consolidation continues to develop remains to be seen, but now is the perfect time to go short, preferably at a spot below where the gap will fill. Once a gap begins to fill, price usually continues until the gap is completely retraced. Thus, a short position just beneath the top portion of the gap is a more aggressive method for attempting to squeeze the most out of such a large jump in price.

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