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Chart Gaps as a Trading Edge

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When a stock or index has a move on the opening such that either: 1.) that day's low ends up being higher than the previous day's high or 2.) the day's high ends up being lower than the previous day's low, this pattern is called a (chart) "gap"; a gap UP in the case of example 1 and a gap DOWN in the case of example 2. As an aid in trading strategy or as an entry 'signal', from the standpoint of making a trade, how reliably will an upside or downside gap lead to a further move in the same direction as the gap.

This question is not completely simple, but there are some guidelines to 'gap' behavior. A gap is simply an sharp imbalance in buy versus sell orders when some new condition or news comes out. For example, bullish news that comes out after the close or before the opening means that the index or stock has to be 'marked up' to get sellers into the other side of the trade. Conversely, bearish overnight news means that the stock or index has to be 'marked down' in order to get buyers coming in. Bullish or bearish news has to be overnight to create daily chart gaps, but intraday news (e.g., Fed action, etc.) can create chart gaps on intraday charts as a stock or an index falls or jumps sharply from the prior intraday period; e.g., on a 5, 15, 30 or 60-minute chart. Mostly, with chart gaps, we are looking at sharp moves occur on the opening and where prices keep going to the upside or downside after that.

SOME BACKGROUND; HOW GAPS ARE CREATED OR NOT CREATED

1. The S&P indexes versus the Nasdaq
Chart gaps are not typically seen in the S&P 100 (OEX) and S&P 500 (COMP) charts. This is because, when there are delayed openings in a number of stocks comprising the indexes that trade on the New York Stock Exchange, due to order imbalances, there is an 'assumed' opening in each stock in that index that is equal to the prior day's CLOSE. You must go to intraday (I use hourly) charts to see the 'true' gap that occurred in the index based on the openings of the stocks that did open at the usual time.

The Nasdaq always opens straight away at a price; there is no 'floor' specialist that is charged with keeping an 'orderly' market and looking for bids or offers in order to open a stock past the opening time because it can be done with less extreme imbalances in buying/selling. Therefore there will be instances seen on the DAILY charts where the Nasdaq 100 (NDX) or Nasdaq Composite (COMP) 'gaps' up or down on the day.

2. Three KINDS of gaps

BREAKAWAY: Upside chart gaps that are made after, or soon after, a prolonged decline and downside gaps that are made after, or soon after, a prolonged advance. Such gaps are typically called 'breakaway' gaps as the trend breaks in a new direction.

RUNAWAY: Chart gaps that form after a move has been underway for a while. These are also called 'measuring' gaps as they often occur in the approximate middle of a move. Runaway gaps are more common in the commodities markets and are seen rarely in the major stock indexes and not often in stocks.

EXHAUSTION: Chart gaps that occur after a price move has been underway for some time and which marks the 'last gasp' so to speak, of the bulls or the last gasps of the bears. Typically these type order imbalances occur when a final bunch of new buyers or sellers gets into a stock or into the market. So-called exhaustion gaps are near or getting near to a tradable top or a tradable bottom; i.e., to near an upside or downside (trend) reversal.

In stocks and stock indexes, breakaway gaps are not as common as occur in the commodities markets versus breakaway or exhaustion type gaps or gaps near the beginning or end of a move. Nevertheless the first chart I'll show has 3 examples of measuring (runaway) type gaps in the OEX, but and these are seen on the hourly chart.

3. Gaps tell two different stories
Chart gaps tell us the point at which a move may be beginning or may be nearing an end point AND 2.) the top end (of upside gaps) or bottom end (of downside gaps) can also show areas where there will be support or resistance respectively. In other words, pullbacks to the area of a prior upside chart gap can also imply an area of support or where buying interest shows up. Rebounds back up to a downside chart gap can suggest an area where resistance and renewed selling will develop.

My next chart, that of the daily Nas 100 (NDX) shows all three of the different type chart gaps; i.e., breakaway (trend 'reversal' type), runaway and exhaustion. The exhaustion gap seen at the July NDX top wasn't more than a 1-point gap, but it was telling nevertheless. The last gap highlighted on the chart below that formed between Thursday and Friday (of last week), initially looked like a breakaway gap suggesting a possible downside reversal. The subsequent rally suggests this is not the case, but I wonder.

On a closing basis, to date anyway, NDX hasn't made much headway above price resistance implied by this gap. The gap was 'filled in' (by subsequent price action), but a renewed up leg can't be assumed just yet. Stay tuned on that!

For really seeing where the chart gaps are, we can compare the daily NDX chart above with that of the Hourly (NDX) chart below. There was some follow through after each gap. The biggest moves tend to AFTER an initial gap in a new price direction. Gaps seen after extremes in the overbought/oversold indicators like the RSI can be followed by the biggest price swings. The downside gap seen around 8/24 was quickly followed by an upside gap as the dominant (up) trend re-asserted itself; this was followed later by yet another upside gap on the way to the recent top.
Gaps do tell a story and formation of gaps are useful trading guides.

SOME STOCK CHART EXAMPLES:

What I'm struck by with these next charts (bellwether stocks Intel & GE) is that there was a significant further move in the direction of the gap (either up or down) after each gap event. Moreover, the gap areas have generally marked an area where significant buying or selling has showed up later. Maybe not immediately and at the exact point where the gap was 'filled in', but the gaps were areas of significance. This is not surprising, since the gaps marked sort of 'sea changes' in the trend where heavy buying overwhelmed selling or vice versa.

With GE as highlighted below, the initial upside gap turned out to be very significant and a good 'signal' to get into calls. The second gap was showing still-significant strength. The 3rd gap (a downside gap) was followed by a significant further sell off. These gaps didn't highlight subsequent future areas of support or resistance overly much, except that the sharp mid-August sell off did hold above support implied by the area of the late-April upside (breakaway) gap.

Sometimes gaps play the role of highlighting future support or resistance, sometimes not. But often there is upside or downside follow through to certain chart gaps, which is the key trading usefulness I find in gap events.

STOCK PRICE GAPS STUDY

A study done by Larry Connors and Ashton Dorkins (recently cited in "Technical Analysis of Stocks & Commodities") involved substantial quantitative research on chart gaps in individual equities and drew on a lot of data: they examined several million instances between 1995 to 2006 when chart gaps appeared from one day to the next in stocks trading above $5 and with a 100-day average of daily trading volume greater than 250,000 shares.

Connors and Dorkins actually found that the strongest SHORT-TERM edge occurred by doing the opposite of what most traders tend to do, which is to buy on upside gaps. To qualify for this study, gap ups had to be at least 2.5%, but ranged up to 25% higher than the previous day's high.

The average returns of stocks that 'gap up' were negative 1-day, 2-days and 1-week later. The fact that subsequent price action after gap events tending to settle back to pre-gap levels is the reason for the old trader's adage that gaps get 'filled in'. The aforementioned research on this subject with equities suggests being selective in buying after a gap up event or not buying at all. I look especially as WHERE a gap appears; that is, does the gap up appear to be the start of a new trend, possibly mid-way in that trend or near the end of a prolonged trend.

Continuing with the study, it was found that the average returns of stocks that 'gap down' were positive. The positive results were even more pronounced when looking at stocks that gapped down by 10% or more. The conclusion of the study's authors was to build trading strategies more around stocks that gap down by 10% or more.

The average 1-week return of stocks after gapping up by 10% or more was a minus 1.14%. The average 1-week return of stocks that gapped down by 10% or more was +2.01%. Interesting!!

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GOOD TRADING SUCCESS!
 

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