Gaps | Continuation Gaps | Exhaustion Gaps | Stock Market

A gap is a chart pattern that consists of two adjacent bars, where the low of one bar is higher than the high of the other bar (Figure 22-1). It shows that no trades took place at a certain price, only at higher and lower levels. Webster's Dictionary defines: "Gap: 1. a hole or opening, as in a wall or fence, made by breaking or parting; breach. 2. an interruption of continuity in space or time; hiatus; lacuna."

Gaps occur when prices jump in response to a sudden imbalance of buy or sell orders. A scary piece of news often triggers gaps. Gaps on daily charts show reactions to events that took place while the market was closed. Had the news come out during trading hours, a gap might have occurred only on intraday charts and perhaps have led to a wider daily range.

For example, a strike at a major copper mine is bullish for copper. If the news comes out in the evening, the shorts become frightened and want to cover. They flood the pit with buy orders before the opening bell. Floor traders respond by opening copper above the previous day's high. The smart money, incidentally, has probably bought copper before the strike was announced. Smart money tends to put on trades when markets are quiet, but amateurs tend to jump on the news.

Gaps show that the trading crowd is spooked, that losers are getting hurt and dumping their positions. When you know that bulls or bears are hurting, you can figure out what they are likely to do next and trade accordingly.

Some gaps are valid; others are phony. Valid gaps occur when the market skips a price level. Phony gaps occur when a financial instrument trades in another market while the market you analyze is closed. For example, daily charts of Chicago currency futures are full of phony gaps. Currencies trade in Tokyo , London , and elsewhere while the Chicago Mercantile Exchange is

A. A breakaway gap. Sell short and place a stop a few ticks above the
gap's upper rim.

B. An exhaustion gap-prices pull back into it the next day. The down
trend is over. Cover shorts immediately.

C. Another exhaustion gap, marked by a lack of new highs after the gap.
Several days of churning offer good shorting opportunities with a stop
above the high.

D. A continuation gap in a downtrend. Go short, with a stop a few ticks
above the gap's upper rim. Prices hit that stop a few days later-no
method is fail-safe.

E. An exhaustion gap, closed two days after it opened. Cover shorts
immediately.

F. A common gap in the midst of a congestion area, closed the next day.
No action recommended.

G. A breakaway gap. Go long and place a protective stop a few ticks below the gap's lower rim.

H. A continuation gap. Add to longs and place a protective stop a few ticks below the gap's lower rim. The gap at the right edge of this chart could be either a continuation or an exhaustion gap. Relatively quiet volume suggests continuation. If you buy, place a protective stop a few ticks below the lower rim of this gap.

All gaps can be divided into four major groups: common, breakaway, continuation, and exhaustion. You need to identify them because each tells a different story and calls for different trading tactics.

Common gaps are rapidly closed—prices return into the gap within a few days. Common gaps usually occur in quiet trendless markets. They are seen in futures contracts for late delivery, in thinly traded stocks, and at sold-out, low-volume market bottoms.

Common gaps show no follow-through — no new highs after an upside gap or new lows after a downside gap. Volume may slightly increase on the day of a common gap, but the following days show a return to average volume. The lack of new highs or lows and indifferent volume show that neither bulls nor bears have strong feelings about the market. Common gaps are the least useful of all gaps for trading.

Common gaps occur more often than other gaps. It takes very little to create them in a dull market. A Comex floor trader at one of our seminars spoke of how he could push gold up or down $2 an ounce on a quiet day. He was known as a big trader and if he suddenly began bidding for 20 contracts at a time, other floor traders stepped back, figuring he knew something. Gold would gap up, and the trick for him was to sell before that gap was closed.

An ex-dividend gap is a common gap that occurs in the stock market on the day a dividend becomes payable. For example, if the dividend is 50 cents, then each share is worth 50 cents less after that dividend is paid. This is similar to a drop in the price of a cow after it delivers a calf. Once the calf is born, the price of the cow falls by the amount of the calf's price because it is no longer included with the cow. Ex-dividend gaps were common in the old days. Today, the average daily range of a dividend-paying stock is greater than the amount of its dividend, and the ex-dividend drop seldom results in a gap.

A breakaway gap occurs when prices leap out of a congestion zone on heavy volume and begin a new trend. A breakaway gap can remain open for weeks or months, and sometimes years. The longer the range that preceded the gap, the longer the subsequent trend.

An upside breakaway gap is usually followed by new highs for several days in a row, and a downside breakaway gap is followed by a series of new lows. There is a sharp increase in volume on the day of the breakaway gap and for several days after that. Volume on the day of the gap may be twice as high as the average volume for the previous few days.

A breakaway gap marks a major change in mass mentality — it reveals a great pressure behind the new trend. The sooner you jump aboard the new trend, the better.

Most gaps are common gaps that are quickly closed. Professional traders like to fade them — trade against gaps. You have to be careful because if you do it mechanically, sooner or later a breakaway gap will clobber you. It takes deep pockets to hold a losing position for months, waiting for a gap to close.

A continuation gap occurs in the midst of a powerful trend, which continues to reach new highs or new lows without filling the gap. It is similar to a breakaway gap but occurs in the middle of a trend rather than in the beginning. Continuation gaps show a new surge of power among the dominant market crowd. The inflationary bull markets in commodities in the 1970s had many of them.

A continuation gap can help you estimate how far a trend is likely to carry. Measure the vertical distance from the beginning of a trend to the gap, and then project it from the gap in the direction of the trend. When the market approaches that target, it is time to begin taking profits.

Volume confirms continuation gaps when it jumps at least 50 percent above the average for the previous few days. If prices do not reach new highs or new lows for several days after a gap, you are probably dealing with a treacherous exhaustion gap.

An exhaustion gap is not followed by new highs during uptrends or new lows during downtrends—prices churn and then return into the gap and close it. Exhaustion gaps appear at the ends of trends. Prices rise or fall for several weeks or months, and then gap in the direction of the trend. At first, an exhaustion gap looks like a continuation gap — a leap in the direction of the trend on heavy volume. If prices fail to reach new highs or new lows for several days after the gap, it is probably an exhaustion gap.

An exhaustion gap is confirmed only when prices reverse and close it. This gap is like the last spurt of a tired athlete. He springs away from the pack but cannot sustain the pace; as soon as others close in on him, you know that he will lose the race.

1. Common gaps do not offer good trading opportunities, but if you must trade, fade them. If prices gap up, sell short as soon as the market stops reaching new highs and place a protective stop above the high of the past few days; cover shorts and take profits at the lower rim of the

gap. If prices gap down, go long as soon as the market stops reaching new lows and place a protective stop below the low of the past few days; place an order to sell and take profits at the upper rim of the gap.

• If a market gaps out of a long trading range on a burst of volume and
continues to make new highs or lows, you are probably dealing with a
breakaway gap. If prices have gapped to the upside, buy and place a
protective stop at the lower rim of the gap. A valid breakaway gap
almost never gets closed. Reverse the procedure in downtrends.
Waiting for a pullback when a new trend has just begun may leave you
on the sidelines.

• Trading a continuation gap is similar to trading a breakaway gap —buy
early and place a protective stop at the lower rim of the gap. Reverse
the procedure in downtrends. Tighten your stops when a trend
approaches its target as projected by the continuation gap.

• A valid breakaway or continuation gap must be confirmed by a series
of several new highs or lows. Otherwise, you may be dealing with an
exhaustion gap. If the market refuses to reach new highs or lows in the
direction of the gap, exit your trade and re-evaluate the market from
the sidelines.

• Exhaustion gaps offer attractive trading opportunities because they are
often followed by violent reversals. When you identify an upside
exhaustion gap, sell short and place a protective stop above the latest
high. Once prices begin to slide, weak bulls will start bailing out. Stay
short as long as prices continue to reach new lows and cover the day
after prices fail to make a new low. Reverse the procedure in down
trends. Because of high volatility, exhaustion gaps are easier to trade
using options, especially buying puts at the tops.

An island reversal is a combination of a continuation gap and a breakaway gap in the opposite direction. An island reversal looks like an island, separated from the rest of price action by a gulf in which no trading took place. It begins as a continuation gap, followed by a compact trading range with high trading volume. Then prices gap in the opposite direction and leave behind an island of prices. This pattern occurs very seldom, but it marks major reversal areas. Trade against the trend that preceded an island.

It pays to watch for gaps in related markets. If gold shows a breakaway gap but silver and platinum do not, then you may get a chance to position for a "catch-up move" in a market that has not yet become frenzied.

Gaps can serve as support and resistance levels. If greater volume occurred after an upside gap, it indicates very strong support. If greater volume occurred before the gap, then support is less strong.

Technical indicators help identify types of gaps. The Force Index (see Section 42) is based on price and volume. If Force Index shows only a minor change on the day of a gap, it is probably a common gap. When Force Index reaches a record high or a low level for several weeks, it confirms breakaway and continuation gaps.

Intraday charts show many opening gaps, when prices open outside the previous day's range. When there is an imbalance of public buy and sell orders before the opening, floor traders open markets higher or lower. If outsiders want to buy, floor traders sell to them at such a high price that the slightest dip will make them money. If customers want to sell, floor traders will take merchandise off their hands—at a price that is low enough to profit from the slightest bounce. Professionals play it cool —they know that crowds seldom stay excited for long and prices tend to pull back into yesterday's range. They sell above that range or buy below, waiting to unwind their positions and take profits when the opening gap is closed.

If you trade the S&P 500 futures, remember that their opening gaps are almost always closed. If the S&P 500 futures open higher, they almost always sink during the day and touch their previous day's high. If they open lower, they almost always rally during the day and touch their previous day's low. Savvy day-traders tend to sell short higher openings and buy lower openings. This is not a mechanical method —you have to buy or sell only after indicators tell you that the force behind the opening gap has been spent and the market is ready to close the gap.