A minor island bottom pattern formed at recent lows in Nasdaq as I noted this past weekend in my Index Wrap and as reproduced in my first chart below. The reason I say 'minor' is that most often major 'island' tops or bottoms form at more major reversal points, NOT well into an uptrend or downtrend.

ALL CHARTS REFLECT THE CLOSE AS OF FRIDAY, 4/27/12.

The island pattern, of the top OR bottom type, consists of matching price gaps. I'll review the chart GAP phenomena and why a possible Nasdaq 'island top' is also something to consider.

The Nasdaq index chart I focused on this past weekend (in my Index Wrap was the Nas 100 (NDX) daily chart seen first with two highlighted island type bottom patterns. I'll go on to discuss the significance of price gaps in general and why, unlike in the Nasdaq market, you DON'T tend to see them in the S&P and Dow daily charts.

Now of course in the chart above there are a number of NDX chart gaps that formed as seen on the left, where overnight news or perceptions caused the next days' LOW to be higher than the prior day's HIGH; i.e., this is an upside price gap. (This same pattern is seen on declines, only in that case, the next day's high is lower than the prior days' LOW; i.e., downside price gaps.)

The pattern of numerous upside price gaps occurred many times on the strong COMP advance, followed by a couple of downside gaps at the recent top.

CHART GAPS IN GENERAL:

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.

Upside or downside gaps that occur early in an emerging NEW trend in stocks or an index, tend to be significant because its a visual clue that something is changing in perceived value for that stock or index. In an upside reversal of the dominant trend, buyers are finding reasons to switch to the buy side. In a downside reversal, selling comes in strongly and buying starts drying up. Gaps in emerging uptrends or downtrends are thought of as reversal type gaps and are signs of a new intermediate price trend.

Price gaps are NOT seen (or only rarely) on the S&P 500 index (SPX) or Dow Industrial (INDU) daily charts. Chart gaps are sometimes seen on their intraday charts; e.g., hourly, whereas they don't appear on the 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 usually also means that order imbalances show up in a number of the S&P stocks or Dow stocks; e.g., major sell orders come into the NYSE specialist firm for a stock or for many stocks relative to buy orders held by the specialist.

Using the example of the S&P 500 index in a sell imbalance: 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 may be a delayed opening for a number of key stocks in the S&P and Dow. Such delayed stock openings due to order imbalances are not uncommon.

With the NYSE in publishing an immediate daily 'Open', the convention or rule for the S&P and the Dow is to imply an index Open for stocks not yet trading based on their 'last' price, which is the prior day's Close. Based on this convention, there is no apparent chart 'gap' that appears as the Open for the stocks not yet trading is to use the prior day's Close as the 'open' and which is a price that's not below the prior day's Low. This even though, when the stock actually gets trading, the first traded price is well UNDER the prior day's Close.

The S&P 500 (SPX) daily chart below shows the same period seen with the NDX and COMP daily charts above; NO upside price gaps seen here, at least on the DAILY chart.

The hourly SPX chart seen next shows price GAPS because the first trade of the hour reflects the actual price of all the stocks making up the index. If some stocks aren't yet trading, the index value reflects only those that are and is then higher or lower that the 'official' daily Open.

TOPS OF UPSIDE GAPS TEND TO SHOW UP AS SUBSEQUENT 'SUPPORT'

BOTTOMS OF DOWNSIDE GAPS TEND TO 'BECOME' LATER RESISTANCE

The reason to go through an explanation of the different treatment for Nasdaq versus NYSE Opens is:

#1.) Chart gaps that show up in COMP and NDX daily charts and DON'T show up on SPX, OEX and INDU charts, will show up on their hourly charts. This is of TRADING interest because:

#2.) The top of upside price gaps often 'become' or show up as subsequent support on pullbacks. Conversely, the bottoms of downside price gaps often show up as subsequent resistance. This as opposed to when we see chart gap and may think 'so what'!

Generally, gaps below the market tend to act as support areas and gaps above the market suggest resistance and area of likely selling interest. 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 and 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 for some time to come.

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.

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. Conversely, 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.

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 reversal gaps OR so-called measuring gaps are created; i.e., gaps appearing about MIDWAY in a move.

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.

'ISLAND' BOTTOMS OR TOPS:

Sometimes, as suggested above, the action that follows a final downside or upside price gap (a so-called exhaustion gap) will be another gap in the OPPOSITE direction that leaves a single bar or cluster of bars isolated, with gaps before and after the island pattern. This leads to the further description of this pattern as an island formation or an island reversal pattern. These two opposing gaps (one up and one down or vice-versa) often 'signals' a significant reversal of the trend.

RECENT NASDAQ HIGHS; A POSSIBLE ISLAND TOP?

Here comes the kicker with the recent Nasdaq highs. It looks like an island top.

This interpretation of a possible pivotal top in the big cap Nasdaq 100, not necessarily a major top, but one keeping with tops seen in May in the last two years, tends to 'fit' with the concept highlighted below; i.e., the idea that NDX has reached significant resistance implied by the upper end of its long-term uptrend channel. A correction back to or toward the lower end of this broad long-term uptrend channel wouldn't be out of keeping with the pattern traced out over recent months and years.

ISLAND TOPS AND BOTTOMS IN STOCKS

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 20, announces better than expected earnings and then gaps higher by opening at 20.5 or 21 and trades up from there; the (upside) chart gap is the non-traded range between 20 and 20.5 or 21.

AN ISLAND TOP IN FORD MOTOR (F):

AN ISLAND BOTTOM IN HOME DEPOT (HD):

May all your islands lead to favorable trades or major relaxation!


GOOD TRADING SUCCESS!