In my most recent (5/20) Trader's Corner article, part of an ongoing series of concepts in technical analysis, I discussed chart gaps in terms of how price gaps can occur when trends accelerate in terms of upside or downside momentum. Carrying on with this topic will be terms of when price 'gaps' show up at reversals of the dominant trend.

First however, I'll pause and look at the current market in terms of whether the market has completed its downside correction.

LIKELY DOUBLE BOTTOM IN PLACE:

I wrote in my recent weekly 'Index Wrap' (5/22) piece that it seemed likely that a double bottom was setting up. I was thinking more of an approximate re-test of the prior May (1066) low in terms of the S&P 500 (SPX). However, Wednesday's 1041 SPX low was within a hair's breath of the February 1045 bottom. Each recent downswing was approximately equal, which is a common pattern and made for a measured move objective.

The lower weekly low on Wednesday, followed by a rebound, a 1-day upside reversal (a decisive new Low, followed by a Close above the previous day's close), followed in turn by strength yesterday and today suggests 'confirmation' of a bottom. This is not to say how long it might take for a substantial retracement of the sharp May sell off.

Beside price action, which is the determinant factor always in judging a reversal, my key call to put (volume) ratio indicator as a yardstick of trader 'sentiment', flashed a buy 'signal' 3-days before the final bottom; within the time frame of the 1 to 5 day warning this indicator often provides. See the chart below.

CHART GAPS: AT TREND REVERSALS (TOPS & BOTTOMS):

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.

As I discussed in my last Trader's Corner article (5/20), common gaps or minor price gaps between one day's high or low and the next, occur frequently enough so that you may not notice them after a while, as highlighted on the chart below:

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

Circles are drawn around most of the 'common' gaps in the chart above and as you can see, they are quite numerous, at least for this stock during the period shown.

RUNAWAY OR BREAKAWAY GAPS (AKA 'MEASURING' GAPS):

The sometimes numerous nature of gaps should not obscure the important pattern information sometimes provided by certain other price gaps. Sometimes after there is a trend already established, a stronger, more accelerated move begins and another, even bigger, price gap may occur that qualifies as a breakaway gap. A breakaway price gap is showing that one side or the other (buyers or sellers) has become more firmly in control. There may be more chart gaps seen around the early part of a trend phase that has accelerating momentum either up or down.

Accelerating momentum refers to prices going up or down at a faster and faster rate; e.g., a stock was going up about 7% a year, but along comes a year or years where it starts averaging a 15% year over year gain. Or the stock or an index starts falling at an increasing rate and chart gaps often develop at these junctures, often of the 'breakaway' type gap when trends go from up to down or vice versa.

Looking at downside moves and the periods where prices accelerate downward at a faster and faster rate, the nature of bear markets is such that they can tend toward steeper losses, in percentage terms, in a shorter time span than bull markets.

Bear markets are much compressed in terms of time. Our most recent example is of course, this May's sell off, which in only 17 trading days equaled the Feb-April 3-month rise. In terms of price, a bear market may not go down much more than a bull market goes up, but it will do it faster most times.

After the trend is moderately to well-developed, there may again be a bigger price gap or gaps that could qualify as the runaway (aka, 'breakaway' gap) variety such as in the chart below. A trend reversal begins with an exhaustion gap which I will describe further on.

Gaps at what could be the 'middle' stage of a trend are important, as it suggests in stocks anyway, that a second wave of possible new sellers (or buyers, in the case of upside runaway/measuring gaps) are coming in and are MORE convinced about the staying power of the trend. In the case of the bear trend shown above, we could say that investors who were convinced that the stock would come back are now more discouraged about the prospects for an earnings recovery, etc. and now exit the stock.

The downside runaway gap, which can have a 'measuring' implication of it appearing about half way in a move, often is brought about by an earnings release that is confirming a deeper slide for the company or in the case of an index, a deeper slide in the overall economy. The reverse is true in upside runaway/measuring gaps.

In stocks in a bull trend, traders and investors are reacting to news that is increasing favorable to an uptrend; enough so that they are willing to pay up for the stocks they're interested in and this includes willingness to pay up for an opening where prices gap HIGHER. Action in individual stocks may be part of a general market upswing.

The overall up volume numbers published by the exchanges will start to surge on days with the kind of big moves where gaps are also often occurring. The willingness is buy on up ticks is what is shown in the up volume numbers. Gaps come from this kind of thrust, a result of increasing bullish sentiment.

EXHAUSTION GAPS:

The exhaustion gap, which is also highlighted on the chart above and which tends to be more common in the futures markets than in stocks and stock indexes, occurs only 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.

As pointed out in my earlier article on chart gaps, daily chart gaps between the high or low of one day versus the next, occur with the all-electronic exchanges like the Nasdaq as the 'Open' always matches the closest bid/offer pairs. There are no delayed openings like on the NYSE.

An example of what now looks like an exhaustion gap is seen in the recent Nasdaq Composite (COMP) chart below:

Sometimes (not above) the action that follows an exhaustion gap is another gap in the opposite direction that leaves a single bar or cluster of bars isolated, with gaps before and after, that lead to the further description of this pattern as an island formation or an island reversal pattern.

Without subsequent price action that suggests a top or bottom is forming, an exhaustion gap would initially be hard to distinguish from a common or runaway gap. This type gap is the most likely to 'signal' a trend reversal, especially in conjunction with a subsequent gap that forms an island pattern per my next chart.

The isolated 'island' pattern is more often seen in commodity price charts, especially futures, than in stocks but it is seen in equities occasionally.

If a gap or gaps remain after a period of 2-3 days to 2-3 weeks, the probability of there being a final top or bottom in place increases substantially. In stocks, you also see these reversals occurring on the way down or way up, rather than at the closer to the absolute highs or lows.

An island top is the opposite of the island bottom and occurs when prices gap higher (an 'exhaustion' gap) after an uptrend has been underway for some time, then trade for one day or for several days where the lows remain above the gap, leaving this space completely 'open'.

This price action is then followed by a gap down that results in open space below the single bar or bars or there will be gaps on either side of the cluster of bars making the formation resemble an 'island' as in my next chart:

A new trend begins from an area of the island top seen above, making this a trend reversal type pattern. The island top is typically left intact and prices do not fill in the gap(s) that created the isolated bar(s), at least during the duration of the trend that follows over the next weeks. Months or years later of course, the gaps may get 'filled in'.


GOOD TRADING SUCCESS!