Breakaway gaps are the most bullish of all gaps. They occur when a stock or index gaps above resistance on high volume.High volume is key! Breakaway gaps occur usually when a stock or index is in an extended downtrend where a clearly defined downtrend resistance line can be drawn. Note, breakaway gaps can occur with stocks that have horizontal resistance, however experience tell me the ones that have a clearly donwntrend resistance work better. The gap here is very bullish because it takes out the resistance by gapping above the downtrend resistance line on high volume. These gaps are usually the start of an extended uptrend and may not be filled for a long time.

 

This is where inexperienced traders can fall into a trap. There is an old saying on wallstreet that gaps must be filled. Therefore, when a breakout gap occurs, many traders get caught and lose money by shorting the gap because they think it must be filled. Breakaway Gaps may eventually be filled, however they represent a change in trend and are very bullish. Typically, the gap may take months, even years to fill. Breakaway gaps represent a low risk entry point for a long position if they are bought early on, especially on the day the gap occurs. Breakaway gaps, sometimes upon breakout, will pullback for a few days. Use this pullback as a gift and either add to your long posistion or go long if you missed the day of the gap up.
 

Breakaway Gaps and Negative Divergence

How should one trade breakaway gaps? The breakaway gap should be bought ideally on the day of the gap up or on a pullback shorly after the gap occurs. Now, the big question is, how long should one hold the postion? One thing I've found very useful is that after Breakaway Gap has a substantial run-up, Negative Divergence usually warns the trader that the rally is over, and to exit the long position. Therefore, when buying breakaway gaps, look for negative divergence as your warning to exit the position. For more information of negative divergence, go to the education section on Negative Divergence.

 

The chart below of Yahoo is a good example of breakaway gap and it’s bullish nature. Yahoo was in a downtrend from May of 2002 until early October 2002, as noted by the clearly defined downtrend line. The gap on October 12th cleared this downtrend resistance line on very high volume which confirmed the pattern. Many traders shorted Yahoo on the day of the gap up as well as many days afterward based on the poor fundamentals of this internet stock. This decision obviously was unwise and cost many traders lots of money, especially those who added to their short position on the way up.

Notice how Negative Divergence occured after the substantial rally - the astute technical trader would have used this to exit their long position.

This example also illustrates how trading in the short term off fundamentals can get one into trouble. Long term, fundamentals eventually win out, but in the short term, technicals rule. Read the section on Technical Analysis for more information on technicals vs. fundamentals.