Monday 30 March 2009
Price gaps are a common occurrence on charts and yet all too often, the technician glosses over their significance or misinterprets their meaning.
Let’s first begin with a definition: A price gap is an area on a chart (bar or candle) in which there are no trades. Gaps ('open spaces') can occur for a variety of reasons and should be watched carefully because they may be an indication of a significant change in the underlying market conditions or psychology of the market.
Gaps can appear on long-term weekly and monthly charts, but are more frequently found on daily charts. A gap occurs because there is a significant market development in which price rapidly changes and no trades occur between the initial point and the next subsequent trade point.
For example, a terrorist attack may result in gold or oil prices gapping higher, or an announcement of Chapter 11 proceedings may lead to a stock gapping lower.
There are 4 types of gaps that the technician needs to be aware of because each has its own interpretation.
Common Gap
As the name suggests, common gaps are generally of no significance; they are frequently found on price charts. They can be caused by a stock going ex-dividend.
Common gaps are generally 'filled' within a short period of time. Filled is the common term for when the price retraces back to the previous level and closes the gap. It's important to be able to recognize common gaps and not fall into the trap of thinking that they are signals of market strength or weakness.
Breakaway Gap
Breakaway gaps are the ones that astute traders watch for because they can be used to identify the beginnings of a trend. Let’s first look at where we find this type of gap.
Generally speaking, breakaway gaps occur at the completion of an important pricing pattern and signal the commencement of a significant market move.
Markets often get caught in congestion areas (i.e. an area in which prices range trade for a short period of time as prices fail to penetrate support and resistance levels).
To break out of theses areas requires market enthusiasm (either positive or negative) or a fundamental development that causes prices to 'break out'. Breakaway gaps usually occur on heavy volume.
A stronger signal is given if volume does not build until the gap occurs. The point of the breakout now becomes the next support level (upside breakout) and resistance (downside breakout).
It's important at this point to correct a myth commonly associated with gap analysis that “gaps are always filled”. This simply is not true. As a rule, breakaway gaps are not filled because the market has shifted direction.
Runaway Gap (aka Continuation Gap)
After a market has found direction and the trend is established, it is common for a runaway gap to occur. The reason this type of gap develops is that interest in the market increases as traders waiting for the pull-back give up and decide to buy in instead.
In an upward trending market, runaway gaps are a sign of strength and in a downward tending market, a sign of weakness.
Runaway gaps are used by some traders as a way of 'measuring' how much further a trend has to run. The most common method is to use the distance from the start of the trend to the gap as the half way point on the length of the trend.
Exhaustion Gap
Exhaustion gaps are those that appear near the end of the trend and occur after the other two types of chart gaps have been identified. They are identified by high volume and large price difference between the previous day’s close and the new opening price.
They are often mistaken for a runaway gap rather than as a signal that the trend is nearing an end.
Exhaustion gaps occur as the market enters a state of panic and prices move sharply; investors pile in on the idea that the market is about to run away rather than correctly seeing that the trend is almost complete.
Exhaustion gaps are identified by the exceptionally high volume of trading and the fact that the gap is filled within a short time frame (i.e. when prices close under the last gap). Exhaustion gaps are a signal that the market is at a turning point.
Hindsight Is 20/20
Price gaps can signal the start of major uptrends or downtrends. Traders also use them to predict how high or low prices will go. However, gaps are most useful and easily identified and understood after the market is over. Labeling gaps by type beforehand is then, an inexact science at best.
*Reprinted (and modified) with permission from Guy Bower.
About the Author
Guy Bower (www.guybower.com) is an adviser and trader in option markets.
Sole Director and shareholder of GT Publishing Pty Limited and www.protraderdigest.com
He holds a Bachelor of Commerce (Banking and Finance) from the University of Canberra and a Diploma in Financial Services from AFMA (the Australian Financial Markets Association).
Guy has been a technical analyst and broker providing research and trading advice to clients. He has also been a Director of an Australian funds management company specialising in options trading in global markets.
"Guy Bower is one of the few Australian’s who is a successful trader and prepared to share all the tricks and traps of options to have you trading like a pro.” Peter Spann
Guy is the author of 'OPTIONS: A Complete Guide For Australian Investors' and 'Traders and HEDGING: Simple Strategies for Protecting Profits' both published by Wright books.
Guy’s additional qualifications include:
Over 10 years of futures and futures options trading experience.
He has advised FICS (the Financial Industry Complaints Scheme) on options trading.
He has had over 200 articles published in various magazines and newsletters including:
Shares Magazine
Asset Magazine
Your Trading Edge Magazine
Shares Weekly
Active Trader Magazine (US)
Trader Magazine (Europe)
The Iris Report
Plus his own ‘Weekly Updater’ newsletter and has been quoted in the Sydney Morning Herald and Australian Financial Review newspapers.
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