In my most recent (5/12) Trader's Corner article, part of an ongoing series of concepts in technical analysis, I described how trendlines can be used to form trend channels. This 4th in my article series moves on to the significance of chart gaps as they relate to current price levels relative to where a trend may be headed.

[Note: The Trader's Corner series has the most current article on top, with the older dates reachable by scrolling down once you've clicked on the Trader's Corner TAB at the top of the Option Investor.com Home page.]

A key purpose I have with this article series is to get them into our Trader's Corner archive again. Once there I can refer to a prior article for an explanatory piece on some aspect of technical analysis. Those who want the further explanation then have it. Those who don't need not go there.

RECENT MARKET WEAKNESS:

I have of course gotten some e-mail on what I think is going on as the major indexes sink back to near lows that were distorted lows that wouldn't be reached again due to the 'flash' mash up that occurred on the infamous recent Thursday (5/6).

Regardless of HOW a low was made, once the market is in a full-blown downside correction, there's a tendency for prices to re-test that prior low. Exceeding a prior low in a typical bearish (down-up-down) correction is common also.

There has also been the tendency for chart gaps to appear recently, which is the subject of most of the rest of this piece.

An upside price gap is formed when any stock, index or other traded item has a Low that is the above the prior bar's High. A downside occurs when the High is below the previous bar's Low which is what is seen on the Nas Composite chart below.

On a daily chart, where price gaps are the most significant, a gap is the space between two consecutive day’s price ranges where no trading took place on the gap down or gap up day. Such gaps have various degrees of significance in terms of predicting possible trend continuations or reversals that may be underway. The first COMP gap down day see below preceded extreme further weakness and this is common with gap events.

Most price gaps occur on overnight news coming out after the close of trading; e.g., company earnings announcements or commodity stock reports, etc. Any reports or overnight news construed as more bullish or bearish than was motivating traders/investors in the previous trading session.

It should be noted that gaps are rarely seen on the S&P 500 index (SPX) or Dow Industrial (INDU) daily charts. Minor gaps are sometimes seen on their intraday charts; e.g., hourly but not at all on daily charts. Why? Gap 'events', such as on some overnight news that creates a surprise and causes sharp selling or substantial buying on the market opening often also means that order imbalances show up in a number of S&P stocks; e.g., substantially more sell orders come into the NYSE specialist for a given stock, relative to buy orders held by the specialist firm.

Using the example of a downside move and since the specialist firms are charged with maintaining an 'orderly' market and in order to gain a bit of time for buy orders to come in or for the specialist to calculate what they can and need to buy (they are the buyer or seller of 'last resort'), there is frequently a delayed opening for a number of key stocks in the S&P and Dow. Delayed stock openings due to order imbalances are not uncommon.

As the NYSE also wants to publish an 'Open', the convention or rule for the S&P and the Dow indexes is to calculate an index Open for stocks not yet trading, based on their 'last' price or the prior day's Close. Based on this convention, there is no apparent chart 'gap' as the Open is the same as the prior day's Close. This even though, when the stock actually gets trading, the first traded price is well UNDER the prior day's Close.

To get an idea of a gap area in the S&P 500 (SPX) and the Dow 30 (INDU), you can look at intraday timeframes like 30 or 60-minute charts to see sometimes small gaps that appear. There is no precise way to see the true extent of a daily chart gap based on the way the S&P calculates the S&P indexes and Dow Jones calculates the Dow 30 (INDU) Average. Be that as it may, use of the Nasdaq index charts, shows us where stock market gaps get 'filled' in or do not get 'filled in'. More on that later.

With individual stocks, upside or downside chart gaps are apparent on a bar or candle chart, as the opening price is the actual first trade; e.g., GE closes at 17, announces better than expected earnings and then gaps higher by opening at 18.00 and trading up from there: the (upside) chart gap is the non-traded range between 17 and 18.00.

Unlike the S&P/Dow, chart gaps are not uncommon in the NASDAQ indexes (COMP & NDX), as they have no delayed openings; match ups are made electronically based on whatever orders are in the electronic trading system. You probably have noticed the resulting Nasdaq chart gaps on sharply higher and lower openings that keep going in the opening direction. This may be puzzling when you do NOT see any similar chart gaps in the S&P and Dow indexes when some event has triggered a broad based reaction and NOT just in the Nasdaq market.

GAP SIGNIFICANCE:

Well, it took me long enough to get to the real meat of this article. We see a chart gap and 'so what'!

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, index or commodity, significant new influences affecting the market’s perceptions of what the current and/or future price level for that item should be, causes an immediate adjustment in the opening price during regular exchange hours.

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 where buyers were willing to come in; i.e.

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 liked to have sold more in the area where prices had previously 'gapped' down.

There is a common saying that 'gaps get filled in' 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, as they (the gaps) don’t always get 'filled' or not for a long time anyway.

To see situations where gaps do NOT get filled, we need to differentiate between some different types of gaps and see gaps that indicate a shift or jump to a faster rate of upside or downside MOMENTUM; as when runaway or measuring gaps are created.

Gaps that are part of ongoing trends and that 'signal' an acceleration of upside or downside momentum are part of continuation patterns. Gaps that begin new trends become the kick off to a trend reversal. First I'll discuss the most common type of gap, called (guess what!) common gaps.

COMMON GAPS:

So-called 'common' gaps occur frequently, are simply part of normal price activity and are not especially significant; these are the gaps that 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, resumption of trading can easily result in a price gap.

Examples of COMMON gaps are found in the middle of the chart below, along with the other types of chart gaps that are discussed following this explanation of common gaps.

CHART EXAMPLES BELOW ARE TAKEN FROM MY (ESSENTIAL TECHNICAL ANALYSIS) BOOK FOR ILLUSTRATION OF THE PRINCIPLE INVOLVED.

Beside intraday trading halts in stocks, overnight news affecting equities occur frequently as various economic and business reports are released after regular trading hours, as are earnings reports and to some extent, other companies announcements that might materially affect a related stock's price.

Given the extent of after hours, or 24-hour, trading, there is some ability for participants to react to news in marking prices up or down, but the official stock price record occurs only during regular trading hours and because of this, gaps are even more prone to develop.

For the most part, price gaps occur frequently on chart types that display the session low and high. Gaps will of course not be seen on close-only line charts. Point and Figure charts will account for the up or down jump that causes the appearance of a chart gap as if there were actual trades that occurred in the gap area.

BREAKAWAY GAPS:

A breakaway gap, as the name implies, is a gap that bursts out of the pack, so to speak; a gap that develops when prices often jump well above or below what has been the normal trading range up until this gap event.

This type of gap typically marks a first 'signal' of a trend reversal; e.g., the trend was up, but then a downside breakaway gap occurred which was the beginning of a trend reversal from up to down (a trendline break was also involved), as can be seen in the chart below, also of Altera Corp.

The type of breakaway gap that occurs after the trend is already well-developed, called a measuring or runaway gap is also noted on this and other charts to follow.

The more volatile stocks have more of a tendency for gaps than others; the very widely traded stocks will tend to have fewer breakaway type gaps that dramatically initiate trend reversals.

The breakaway gap will tend to either just get filled in, or never quite completely, during the price move that follows it; either buyers are eager to buy dips back toward the breakaway gap area or sellers are active on selling rallies that approach such an overhead gap.

Breakaway gaps are milestones on a chart and are widely followed. Once a price move is well past and during a later trend, prices may get back to a prior breakaway gap area and this occurrence now lacks any special significance.

RUNAWAY OR 'MEASURING' GAPS:

A runaway gap or as it's also sometimes called, a measuring gap, describes a gap occurring when a trend accelerates in the direction of the trend indicated by the breakaway gap, either to the upside or downside. We tend to see more of this type upside gap in the second phases of bull and markets when there is increasing trading interest, particularly public interest, in a stock or the overall market. A series of these gaps can occur, but a lengthily series of such gaps tends to be more common in the futures markets.

The reason a runaway gap is also sometimes called a 'measuring' gap is that such price gaps sometimes have a measuring implication for the further possible upside or downside potential of the move underway. This because such gaps often (not always) appear about midway in a price swing; e.g., seen below in a revisit of the earlier Altera stock chart. The runaway/measuring gap suggested that the NEXT move from the $30 area might carry as far as the first advance from the 14 area to 30; in fact the next ALTR up leg went to 65.

GAPS THAT DO AND DON'T TEND TO GET 'FILLED IN':

Gaps that tend to get filled in include:

1.) Upside gaps occurring within an overall down trend; i.e., a significant prior upswing high is not exceeded AFTER the gap.

2.) Downside gaps occurring within an overall up trend; i.e., a significant prior downswing low is not exceeded after the gap.

3.) Gaps occurring within a sideways trend or within a trading range.

Gaps that might NOT get filled in during the current trend:

1.) Breakaway gaps

2.) Runaway or measuring gaps

It’s the EXCEPTIONS (to the rule of thumb) that tend to kill you, trading wise; this when you start to assume that technical patterns won't 'fail' you and you DON'T protect yourself by using exit/stop points if you are wrong in your assumption(s).

I'll carry on in my next Trader's Corner with some more on chart gap types and phenomena and the valuable input it can be in making trading decisions.


GOOD TRADING SUCCESS!