Regardless of your level of expertise, understanding the various stock order types is crucial for making informed investment decisions. Before you learn about order types, you must understand one of the top considerations when choosing your preferred order type: Price gaps. Many factors cause price gaps. Unexpected news, events, such as earnings reports, political developments, or natural disasters, can cause a stock's price to move quickly and dramatically, resulting in a price gap. Traders unprepared for such events may find themselves on the wrong side of a trade or unable to execute it at their desired price.
Where do price gaps occur?
A price gap occurs when a sudden and significant difference occurs between a stock's opening and closing price. Large trades or changes in trading volume can also cause price gaps. For example, suppose a large institutional investor suddenly sells many shares. In that case, the investor saps up all the nearest buy orders, which can cause the stock's price to drop quickly to a price acceptable to the next set of buyers and create a gap. There are four main types of price gaps:
- Common gap. A common gap is a typical one that you often might come across in charts, resulting from regular market movements. It often shows up when little trading activity is unrelated to important news or events. Common gaps are rapidly filled, and the price recovers to its prior levels.
- Breakaway gap. When the price moves over a support or resistance level created during a trading range, it creates a breakaway gap. A breakaway gap occurs when the price uses a gap to exit a well-established trading range. Chart patterns, such as a triangle, wedge, cup and handle, rounded bottom or top, or head and shoulders pattern, create a breakout gap.
- Runaway gap. A runaway gap occurs in the middle of a trend and is a sign of solid momentum in the current direction. As the price suddenly picks up speed and keeps moving in the same direction, a gap forms behind it. During an uptrend, it signifies an increase in buying of an asset, whereas during a downtrend, it represents an increase in selling the stock.
- An exhaustion gap. An exhaustion gap indicates the trend is losing steam that occurs on a chart at the end of a prolonged trend or a significant move in the stock price. It typically appears as a sudden spike in the opposite direction of the trend, indicating that the market is losing momentum and that a reversal may be imminent. This type of gap can be either bullish or bearish.