There are important clues to stock trends that can be seen in various kinds of chart 'gaps'. Knowing where we are in a trend, (beginning, middle or end) is half the trading battle.

MY E-MAILBAG:

From last week:

"I am seeing a lot of gaps in charts recently. perhaps you can comment on them. is it true what they say? gaps get filled?"

Today (5/18/11):

"... and how do you see the market with today's rally?"

MY RESPONSES:

As to my current technical outlook, the pattern here looks (so far) like a fairly 'normal' correction. The form that corrections tend to take is a sell off of a few or more days, a rebound that's isn't prolonged or particularly strong, followed by another sell off that often carries farther than the first decline. This pattern is known as an 'a-b-c' type correction or as I refer to it often as a down-up-down corrective pattern. The 'normality' of the correction is one thing; the fact that we're seeing more of these down-up-down corrections suggests slowing upside momentum.

As you can see from the S&P 500 (SPX) chart, I've highlighted the a-b-c correction, which seems likely to have come to end with yesterday's low just under support implied by the 50-day moving average. Yesterday's Close was back above this key average. The 1320 support I had indicated this past weekend was based on support implied by the top end of the prior upside SPX chart gap. More on chart gaps to follow.

Moreover, yesterday's low was accompanied by an 'oversold' extreme 1-day reading on my trader sentiment indicator seen above. The moving average pattern, plus the rebound from implied technical support, plus the low bullish expectations of traders, bodes well as an indication of a tradable bottom.

The longer-term weekly SPX chart also suggests that the lows this week were at trendline support per my next chart. If this trendline is pierced on a weekly closing basis, major support implied by the low end of the index's broad uptrend channel is well under current levels.

Regarding chart gaps and the note from an OIN Subscriber about it being true that chart gaps get 'filled'.

This is a more complex subject than my shorter answer to this person which was:

"Large price gaps that occur on overnight news or news occurring after the close of regular trading often will end up getting 'filled in'. The upper end of such downside gaps tend to act as resistance, the lower end of upside gaps tend to act as support.

So-called 'common gaps', especially in stocks, don't necessarily get 'filled in'. Common gaps in stocks are where there are just slight differences between one day's high and next day's low or vice versa; for example small price gaps brought about by a large buy or sell order that comes in at the opening; e.g., a stock might open a 10 cents higher and go up from there resulting in a what I describe as a common gap.

This is different than other gaps on key news which often DO get filled in in subsequent days/weeks; Alcoa had a 17.65 low on 4/11, with a next day downside gap when it opened just under 17 - high on 4/12 was 17.1. The .55 gap got filled in recently (5/3) when AA hit 18 even. The stock then has drifted lower since then; today (5/18) closing at 16.69. So, the gap got filled but without subsequent upside follow through which is often the case. The upper end of that gap tended to mark a resistance or the beginning of resistance. Conversely, gaps formed below current stock or index prices tend to act as support."

Jumps in daily trading activity when gaps form in stocks and stock indexes also tend to occur with 'normal' chart gaps that were significant to the trend such as seen below; as opposed to 'common' gaps.

The foregoing exchange got me looking at my Dow charts. Gaps tend to be a phenomena that is seen most often with individual stocks, so that's where I'm going with this reply. I wrote a couple of general articles on chart gaps last year that's in the Trader's Corner archive of 5/20/10 and 5/27/10, both of which can be viewed per their date-links.

I highlight gaps below in Verizon (VZ) of being of 'normal' significance; meaning, that such upside OR downside gaps that mark trend reversals. Such gaps may also suggest an accelerating trend. Such normal or chart-significant gaps also tend to 'act as' subsequent support in the case of price declines to prior upside gaps and as resistance in the case of rallies to prior downside gaps. As can be seen below, GAPS DON'T ALWAYS GET 'FILLED IN'; or, may not get filled in for a long period of time. Common gaps don't have such significance. Moreover common gaps aren't usually accompanied by a sizable increase in daily trade volume.

There is another type pattern called an island formation (either an 'island' bottom or island top) that occurs when chart gaps are made on either side of the formation. For example, as seen above (green circle), when prices first 'gapped' down and then a number of trading days later, gapped up. This left an isolated cluster of days that were 'cut off' so to speak from subsequent price action. The island bottom on the extreme left of the chart above.

Chart gaps can have a 'measuring' significance in terms of suggesting a stock or index is at an approximate mid point in its trend, either up or down. A breakaway gap is the qualifying term given to a chart gap where a new trend is just beginning or where there's an acceleration of the emerging trend.

When a trend has been going on for awhile, as in the sideways to lower trend dating from the left-hand JNJ high below, the downside breakaway gap highlighted below can additionally be thought of as a potential measuring gap, occurring around half way in what will be the total move (a decline in this example). Such mid-point gaps may not end up being exactly half way but their formation will suggest that there's a sizable further move to come. Often there are two such successive chart gaps.

My next chart, that of Intel Corp (INTC) provides further examples of 'measuring' type gaps, a 'breakaway' gap, 'common' gaps and an 'island bottom'.

There can be minor island type bottoms or tops that might occur along the way in a trend as in the case of two island bottom type formations seen next in ExxonMobil (XOM). Normally such island 'bottoms' are seen at or near a major LOW, but the more powerful bottoming pattern in XOM was a Head & Shoulder's bottom; the Left Shoulder is not seen as its off my chart.

The meaning of the minor island formations seen below is a bit different here. The first highlighted island bottom takes on more of the role of a 'measuring gap' half way or less in the uptrend. The most recent island formation was suggesting at a minimum that the initial downside gap wasn't a sign that the uptrend was over. Formation of a possible double top ('confirmed' on a break of the 78.8 low) suggests that the upside run for the stock IS probably over.


GOOD TRADING SUCCESS!