Option Investor
Trader's Corner

Breakaway Gaps: What's the Theory and What's Behind Them

HAVING TROUBLE PRINTING?
Printer friendly version

Standard lore says that gaps will be filled. Not always. Rather, not always immediately.

Annotated Daily Chart of Agilent Technologies:

Note: My articles are always prepared in advance of publication, and so charts do not always feature current prices. As of the morning of February 8, A had still not filled that gap.

Prices tend to behave differently after a breakaway gap than they do with some other types of gaps. Breakaway gaps are often not reversed, or at least not immediately. Anyone going short Agilent's stock or entering a bearish option play after that 2006 gap would have found themselves stopped out.

First, what is a gap? In TECHNICAL ANALYSIS OF THE FINANCIAL MARKETS, John J. Murphy describes a gap in simple terms: it's a place "on the bar chart" where no trading has taken place. If you employ candlestick charts, Nison defines gaps in candlestick terms as "windows." In BEYOND CANDLESTICKS, he says that when prices gap higher, "the top of yesterday's upper shadow should be under the low of the today's lower shadow." When prices gap lower, "the low of yesterday's session . . . is above the top of today's upper shadow."

Just as not all definitions are created equally, neither are all gaps. Nison calls any gaps or windows "powerful candlestick patterns," but breakaway gaps can be particularly powerful. Murphy notes their importance as trend reversal signals. They tend to occur when the prior trend has been completed by a major basing pattern and prices gap either higher or lower, beginning a new trend. All authors consulted warn that not every breakaway gap will be valid or a "sure thing," as Pring terms it, but breakaway gaps don't tend to be filled as do other gaps.

In a YouTube webinar, Tom Williams, a former syndicate trader, provided an explanation of how and why breakaway gaps occur. In the instance when prices have been declining during a long downtrend, smart money has been accumulating during the consolidation period, he says, and they're ready to benefit from their accumulation. They want prices to go higher. How do they accomplish that without spending more money than they want? They gap prices above the pattern.

How does this gapping action accomplish their goal? It traps shorts, for one thing. It convinces want-to-be bulls that they're missing the boat. The minimal money spent by big or smart money will then be augmented by those trapped shorts rushing to cover and those new bulls rushing to get on the train. Big money doesn't have to do much more at that point than support prices through an attempt to retrace the gaps and then enjoy the fruits of their labor. The opposite occurs when big money has been distributing stock, of course, or entering net short positions. Prices are gapped lower out of a consolidation pattern.

That's a primary reason that traders counting on a strategy that calls for a gap fill often find their trading accounts depleted by the attempt. Big or smart money intends to have prices go higher when they institute a breakaway gap after accumulation and lower when the institute one after distribution. In TECHNICAL ANALYSIS EXPLAINED, Martin J. Pring points out that "the presence of the gap emphasizes the bullishness or bearishness of the breakout."

Williams would further warn that not recognizing what's happening means that you're attempting trades counter to big or smart money. That's never a strategy that we retail traders want to employ. Williams says that big or smart money already has access to more information than we do, so we certainly don't want to ignore the information we're given in the form of recognizable chart patterns such as the breakaway gap.

The trouble is, as the article "Gap Trading Strategies" in Stockcharts.com's "Chart School" suggests, it's sometimes difficult to identify the type of gap until looking back on the action. How, then, does a trader identify a breakaway gap when it's occurring and differentiate it from other types of gaps that might be filled? First, breakaway gaps tend to occur after a trend has long been in place, but then wanes and a major basing or consolidation pattern forms. The necessity to include two years' of data on A's chart scrunched the candles together and didn't allow for channels to be drawn, but Agilent had been declining in a well-defined descending regression channel for a month when it gapped higher the morning of 8/17/06.

Such gaps usually occur on high volume, although Pring warns that downside breakaway gaps don't require high volume to be valid. Let's drill down on Agilent's chart from that period in August 2006 and see how many of those recognizable patterns were visible.

Annotated Daily Chart of Agilent:

Tom Williams' comments about the genesis of breakaway gaps prompted this article. In the current climate, the topic of breakaway gaps prompts us to look for them now.

Annotated Chart of the IWM:

Because volume information is not available on the Russell 2000, I used the IWM as a proxy.

After a study of that chart and knowing the characteristics of these gaps, it seems relatively easy to distinguish breakaway gaps from running or measuring gaps. We know not to anticipate that breakaway gaps will be filled or at least not until there's been a major trend change again. If we see a breakaway gap these days in a stock that had previously been zooming, with prices gapping below established formations, we won't expect a reversal up through the gap. We're good, right? We know the rules and we can recognize a breakaway gap when we see one.

So, what do we think about AAPL, with this chart snapped January 25? What could we have predicted, if anything?

Annotated Daily Chart of AAPL:

Time will tell, but when this article was first roughed out, before I had the benefit of watching subsequent actions that have occurred since, I typed these words: "AAPL could fall to 117-118 and then attempt a bounce back to the gap level, perhaps even consolidating at that level for a while before final direction is known."

On Friday, February 8, as I'm editing this article, AAPL has so far fallen to a low of 117.27. If AAPL does bounce, because of the nature of the gap and the possibility that it's a breakaway gap, I'd be particularly watch for rollover potential as it approaches that gap area.

What's the point of this look at AAPL's chart? It certainly wasn't to give trading advice in a particular stock. Although I did write the quoted statement late in January and not early in February, predicting the decline to 117-118, you don't even have to believe that. The point is to say that although we know the characteristics of a breakaway gap and they're quite easy to identify afterwards, they're not as easy to differentiate when they've just occurred.

I let the presence of another gap last fall near 145 guide me a bit in determining that this might be a breakaway gap, since the two gaps isolate the whole formation above 145, turning it into a consolidation pattern. Perhaps, though, it's just as valid to say that AAPL had clearly been in a downturn since late in December, and perhaps this is a measuring gap, of the type to be discussed next week.

Clearly, it's possible to argue either way at this point in time. However, knowing about the different types of gaps does give us some information even if we're not sure. Without being certain that our conclusions are right, our information this time is that AAPL might not fill that gap again until a new uptrend has been firmly established and so any who have entered bullish positions now should be particularly careful of their bullish profits as AAPL approaches that gap . . . just in case.
 

Trader's Corner Archives