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Trader's Corner

'Gaps': When It's Important Where Trading Was 'Not'

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Continuing my New Year's resolution with my weekly (Trader's Corner) Wednesday column is to write about technical/market analysis principles reflected in current or recent chart patterns and/or Indicators. (It's up to you dear Readers to send any other questions about a pattern, indicator or whatever (re trading) that might not be reflected in recent or current market activity.) Taking this approach will tend to insure that I keep to relevant aspects or ones that could help you spot a similar pattern or cycle NEXT time to sharpen your trading decisions.

I try to do some of this in my weekend Index Trader column, which is seen online only (not in the Option Investor Newsletter/OIN e-mail, although you'll see a LINK to it at the top. Speaking of links to my 1/7 Index Trader, it also can be viewed/reviewed by clicking here.

A price chart 'GAP' is formed when any traded item, commodity, stock, index, etc. has a low that is the ABOVE the prior session High, which is an 'upside gap'; or, when a stock or index high is BELOW the previous session's Low, creating a 'downside gap'.

Gaps are price areas where no trading took place from one session to the next. On daily charts, this creates a space between two consecutive days price ranges as seen on a bar (or candlestick) chart. Gaps have different kinds and degrees of significance in predicting possible trend continuations or reversals that may be underway.

Price gaps most often occur on overnight news; news that came out after the close of trading, such as company earnings announcements, changes in analyst ratings, something the Fed does, etc.

Generally, gaps below the market tend to act as support areas and gaps above the market suggest resistance and areas where there will be likely selling interest. Since a consensus expectation is 'built into' the last traded price or close of every stock or Index, significant new influences affecting the markets perceptions of what the price level should be, causes an immediate adjustment in the opening price.

Buyers will either be willing to pay more and potential sellers will want higher levels to induce them to sell or sellers will be aggressive in offering the item at lower levels and buyers will not be interested in purchasing unless prices drop especially in the early trading (open) which often becomes the high or low.

UPSIDE GAPS are price areas where buyers were unable to make any purchases, as selling occurred only above the gap area. DOWNSIDE GAPS are price areas where sellers were unable to make any sales as they could only transact at levels below the gap.

This is what is behind the notion that gaps BELOW the market will tend to act a support and gaps ABOVE the market, will tend to act as resistance. A move back down to an upside gap often brings in additional buying, unfulfilled at this lower level from earlier and a rebound back up to an overhead (downside) gap can attract interested sellers that would have sold more in the area where prices had previously 'gapped' down.

There is a common saying that "gaps get filled in"; that is when a market settles down in subsequent days and weeks after the gap 'event'. It would be better to say that gaps TEND to get filled in since gaps dont always get 'filled'.

Gaps can be 'common' and not very significant in terms of the trend or future support or resistance OR can indicate a big shift in the rate of upside or downside MOMENTUM; this is when 'runaway', sometimes called 'measuring', gaps are created. Sometimes gaps suggest the current trend is reaching it's end; that it (the trend) is exhausting itself, which become so-called 'exhaustion' gaps. These indicate an upcoming trend reversal (rather than trend 'continuation').

'Common' gaps are, in a word, common and occur frequently, especially in stocks. Such gaps are part of normal price activity and are not especially significant. These gaps get 'filled in' regularly. In the stock market, because of the tendency to halt trading in a particular company if news comes out that affects the stock price, resumption of trading can easily result in a price gap.

A 'breakaway' gap, as the name implies, is a gap that bursts out of the pack so to speak; that is, a gap that develops when prices jump well above or below what has been normal trading up until this gap event. This type of gap can be the first 'signal' of a trend reversal; e.g., the trend was down, but then an upside breakaway gap began a trend reversal from down to up.

A 'runaway' or 'measuring' gap describes a gap occurring when a trend ACCELERATED in the direction of the trend indicated by the initial breakaway gap or the trend that simply existed beforehand; this can be an upside or downside chart gap. This kind of gap or trend change occurs more in the second phases of bull or bear markets when there is increasing interest, or lack of interest, in a stock or the overall market.

The measuring gap moniker is because of its sometimes 'measuring' implication for the further possible upside or downside potential of the move underway; such gaps often (not always) appear about midway in a price swing.

The first significant gap seen in the daily chart of eBay below, occurred early in 2005 and is best described as a breakaway gap. The decline really accelerated after this price gap. The first time that the stock rebounded to the lower end of this huge gap, it didn't get very far into the gap area, until selling drove the stock lower again.

The second gap, in early-August, was one to the upside and was also a significant gap of the breakaway type., The trend changed after that, although as noted, the rally failed on the first move that was much into the major downside gap of early last year. However, the subsequent pullback toward the lower end of this second gap, found enough buying interest to drive EBAY back up again.

By the way, the significant upside gap in eBay's chart above, occurred after a picture perfect formation of a bullish flag pattern. I say picture perfect because price action over those days traced out something that looks exactly like a down-sloping flag, after a strong run up that preceded this formation; i.e., a more or less straight up move that resembles a 'flagpole'. I show this pattern on the OEX hourly chart that follows, but I won't comment more on this pattern and stick to the subject at hand.

Gaps are not really seen on the S&P 500 index (SPX) or Dow Industrial (INDU) DAILY charts. You have to go to hourly charts to see an 'actual' gap on the SPX or OEX charts. (You won't see upside or downside gaps on the hourly INDU chart at all because of the way INDU is computed even on an intraday basis.)

Gap 'events', such as when some overnight news 'surprises' the market may cause substantial buying or selling orders to show up prior to the Opening. That also means order imbalances show up in a number of S&P stocks (i.e., the orders are MOSTLY buy or mostly sell orders) and the opening gets delayed for that stock or a bunch of stocks to allow more orders on the other side to accumulate. Under the NYSE specialist system, which is going to come to an end I suppose as it becomes fully electronic like the Nasdaq, such delayed openings was part of their duty to create an 'orderly' market.

As the Standard & Poor's Corp. (and it is their Index), wants to publish a daily 'Open' right away, their method has been to calculate the open for stocks not immediately trading, based on their 'last' price, or the prior Close. Based on this method, there is no apparent chart 'gap' on the S&P indexes. An HOURLY chart is used for the S&P 100 (OEX), where the 'Open' is based on the actual first trades, to see where price gaps show up.

The 'exhaustion' gap, which tends to be even more common in the futures markets but is also seen some in stocks and in the indexes, occurs after a trend has been underway for some time. It typically stems from a final last burst of buying or selling activity that 'exhausts' the participants or depletes their accounts.

Without subsequent price action that rallies or falls quickly above or below the GAP area, a so-called exhaustion gap would not be easy to distinguish from other types of gap. Again, this type gap occurs at the END of a move, just ahead of a trend REVERSAL.

As soon as the top end of the downside gap on the S&P 100 (OEX) was exceeded (and note that the initial rally 'failed' to do so), as part of a STRONG move (with heavy volume), this was an excellent technical 'signal' or 'confirmation' that the trend had reversed. Big time! This was going to be a strong rebound!

Most of what I have to say or show about the trading significance of the OEX 'exhaustion gap' is noted on the above hourly chart above.

On to the Nasdaq, where chart gaps ARE apparent on the DAILY chart, as the initial trade for ALL stocks making up either the Composite (COMP) or the popular Nasdaq 100 (NDX) trading index, are computed to give a 'true' opening so to speak. Nevertheless, I end my gap discussion with the NDX hourly chart, as the gaps are easy to see and highlight.

The first gap highlighted, to the left of HOURLY chart below, is the upside price gap of late-November. That burst of buying looked like it could be the start of a sustained advance. Support on the initial pullback did find buying interest/support at the low end of this price gap. When this level was pierced it suggested that prices were headed LOWER.

The recent late-December downside gap, looked like it was might be marking the start of another substantial downswing. The first rally back to the gap area couldn't make headway above it. But a few hours into the New Year (1/3) trading session, the Index reversed strongly to the upside. The decisive upside penetration of the upper end of the late-December downside price gap now suggested that the decline had played out or exhausted itself. This was a strong 'signal' to both exit any NDX puts held and reverse positions into Index calls.

The more recent upside price gaps seen on the NDX chart above had the possible 'measuring' implications of being at (only) a midpoint of a 'runaway' or strong move. As of the close today, the price leg occurring after at least the first smaller gap, has tacked on as many additional points as from the low to that gap area.

Please send any technical and Index-related questions for possible use in my next Trader's Corner article to Click here to email Leigh Stevens Support [at] OptionInvestor.com with 'Leigh Stevens' in the Subject line.

** Good Trading Success! **  

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