Price gaps are very important to any investor because they can signal a critical change in a stock's direction. Gaps occur when a stock trades up or down in price during after-hours trading or in pre-market trading. Understand how to interpret the gap and you can have a distinct advantage for the next potential, major move of the stock. How a Price Gap is Created

A price gap is created when a stock closes at $xx.xx for the day which is at 4:00 PM EST, then in after hours or pre hours trading the following morning is bought up or sold off in price. With the buying or selling during this time when the market is technically closed, the stock then opens up at 9:30 AM EST up or down right off the bat. When you look at the chart of the stock there will be a gap in the daily bars, which means a price gap has been created.

Price Gaps Help Determine Future Price Movement

A price gap up or down in price can actually be a determination of the overall direction the stock will move in the coming days and months. A big price gap on very high volume, which means strong institutional buying of the stock, could mean higher prices to come. You will develop over time an understanding of what different sized price gaps mean in different situations. For example BIDU (BIDU  ) had a price gap way back just last week on very strong volume, and the stock closed that day at $175. Now just a week later you will see that the stock traded above $180 a share. Beware though, if a price gap comes too late in a stock's run it may actually be a sell signal. Like anything, after watching 100 price gaps occur of all different shapes and sizes you will inherit a "6th sense" of where the stock will move in the coming weeks and months.

Why do gaps occur?

The most common reasons price gaps occur is because of earnings and acquisitions. The bigger the price gap, the bigger the reasoning behind it. If you look at price gaps as a means of judging value, you will find they are fairly easy to interpret. Any major event that really changes the value of a stock today or in the future will ultimately affect the stock price.

The Bottom Line

Stock price gaps are caused by after hours or pre hours trading when the stock market is closed. The stock trades up or down in price during these times, and at the opening bell the following morning opens at that most recent price.

Gaps occur in all different shapes and sizes and can be a means of predicting the price movement of a stock over the next several months. Not all gaps tell the same story though, so it is important to conduct your own research to view the history of individual gapping stocks.

Some of the biggest price gainers in 2007 started their multi-year runs with price gaps to the upside. The more you view price gaps the better you will be at interpreting their true value. Sometimes the "how big" is more important than the "why".