No. of Recommendations: 9
GAPS -- Pup's Dirt Time

Edwards and Magee – Technical Analysis of Stock Trends

Link to introductory dirt-time post (for background on this series):
http://boards.fool.com/Message.asp?mid=15614546&post=true

Gaps
, says Bruce, would be the first chapter of any book he would write for traders. (Bruce is mktmans on TMF boards.)

Certain gap patterns are a staple for many traders, so I'm relieved finally to have E&M's chapter on Gaps behind me. However, the subtleties that differentiate the gaps -- especially the runaway gap and the exhaustion gap -- were a challenge. Too much Christmas cheer? Thick-headed? Brain laced with exhaustion gaps? Not sure, but I'm glad I had some background in TA before I tackled these. As E&M point out, runaway gaps and exhaustion gaps are obvious after the fact, but it is impossible for the most knowledgeable TA guru to make a positive id when one is forming. The relentless search for good gap patterns by some of the traders I admire the most, though, is all I need to know of their value.

E&M stress the importance of understanding why gaps form to avoid blindly attaching implications that may or may not exist. I encourage any other TA students like myself to study the charts accompanying Chapter 12 (and read the chapter) rather than relying solely on these notes. Remember, I post these notes primarily as a way to get the subject matter into my own brain, and do not consider them any kind of substitute for reading the actual material.

I'll be attaching some charts to this dirt-time post with examples of each type of gap as I find them. If you have good examples of your own, please provide links.

Chapter 12: Gaps p. 228 – 252

GAPS -- Outline
Overview
A. Common or Area Gap
-- gap within consolidation or congestion
B. Breakaway Gap
-- signals the start of a move
C. Continuation or Runaway Gap
-- marks the rapid continuation of move near halfway point
1. Two or More Runaway Gaps
D. Exhaustion Gaps
-- comes at end of move on peak vol
E. Island Reversal
-- trading range separated from rally/decline or decline/rally by gaps
F. Gaps in the Averages


Definition: A gap in a price chart is an area where no shares changed hands. On a daily chart, a gap represents an area where a stock opens higher than the highest price of the previous day or lower than the lowest price the preceding day. A gap is considered “closed” when a subsequent price trend returns and retraces the range of the gap.

Intraday gaps do not show up on daily charts, and are largely ignored, although they may be more significant than interday gaps.

Gaps that form on a regular basis in thinly traded stocks have little significance for trading.

A. Common or Area Gap

Common or area gaps tend to occur during price congestion, as prices hug the top and bottom boundary lines (supply and demand lines) of the pattern. This kind of gap, which shows up in the “no-man's land” between the boundary lines, forms readily in the more strictly defined patterns such as triangles and rectangles. They are more apt to develop in consolidation than reversal patterns. Most such gaps are closed quickly during the consolidation, but not always.

Implications:

None for the trader, other than to help identify congestion.

B. Breakaway Gaps

Definition:
A gap formed as price breaks away from congestion. Most breakaways from horizontal lines in patterns are gaps, although many don't show on daily chart because they occur intraday.

The Scenario: Take an ascending triangle, for instance, formed by continuing demand for stock meeting large supply at fixed price. Others who want to sell their holding at 1/4 point or 1/2 point above the fixed price either get tired of waiting and join the fixed price group or, knowing the price will go much higher when the supply at the fixed price (resistance) is broken, raise their selling price much higher. When all shares are absorbed at the fixed price, the stock price blows through the vacuum as buyers have to bid up a point or more to get filled. Many breakaway gaps form as price moves away from other reversal or consolidation formations such as head-and-shoulders or trendline penetration.

Implications:

-- Gaps from consolidation give credence to the breakout. False moves rarely gap.

-- Serve as indication of strong buying or selling pressure, suggesting that subsequent moves will carry prices farther, faster, or both. Traders should be prepared for disappointing exceptions to this tendency.

-- No particular measurement expectations are associated with breakaway gaps, but whether or not prices will retrace to the breakthrough point may depend on how strong the volume was before and after the jump. If volume was strong before the gap but weaker as prices broke through and moved away, chances for retrace to point of breakthrough are about 50/50. If stronger volume came in after the gap, chances for near-term return to breakthrough point are slim. If prices do retrace in this case, the “throwback reaction” will almost always stop outside the gap.

C. Continuation or Runaway Gaps

Definition: Gaps that occur not within consolidation patterns or in breakaways from the patterns, but in rapid straight-line advances or declines -- and usually at about the midpoint of the advance or decline. Although these gaps occur less frequently than pattern gaps (area gaps) or breakaway gaps, they are far more valuable for the trader because of their measuring implications for the advance or decline in which they appear. For this reason, they are also called "measuring gaps." Runaway gaps are usually not filled for a considerable time.

Scenario:

In a strong advance from a consolidation area, prices may accelerate for a few days or maybe even a week or more, then lose momentum in the middle of the rally as the very extent of the move invites profit-taking. Then the price takes off again until the reversal or congestion day which ends the move. At just about the halfway point on such rallies -- or in similar rapid declines -- "a wide gap is likely to develop when the runaway is at its height."

Implications:

The pattern should continue as far beyond the gap as the move that preceded the gap "measured directly (and vertically) on the chart." Use log charts to predict the extent of advances or declines. (Advances tend to run -- in points -- beyond the price levels that would be implied on arithmetic charts and declines tend to be more restricted on arithmetic charts.) Err on the side of caution the closer the move gets to meeting the measurement implications.

Identification:

Runaway gaps are easy to spot in hindsight, but hard to differentiate from exhaustion gaps as they appear. Use price and volume action on the day following the gap for evidence.

1. Two or More Runaway Gaps

Definition: Two or (rarely) three continuation gaps in a rapid advance or decline. Unlikely to appear in large, active stocks, but most often appear as thinly traded stock rocket up or down.

Implications:

The halfway point tends to come "when prices are moving most easily and rapidly with respect to number of transactions" (therefore, tendency to gap). If there are two gaps, the halfway stage is most likely somewhere between them. Study charts, looking for thinnest area to ascertain probable midpoint.

--Be cautious as the advance or decline continues, remembering that each successive gap brings the move closer to exhaustion.

D. Exhaustion Gaps

Definition: A relatively wide gap at the end of a rapid and extensive advance or decline.

Scenario: A rapid and extensive advance (or decline) continues to accelerate on heavy volume and a relatively wide gap forms on the next to last day or the last day of the move, just before prices suddenly come to an abrupt halt as they meet "a stone wall of supply" (or demand) on super trading volume.

Exhaustion or Runaway Gap?

1. Runaway gaps occur during a move where the increasing resistance to the momentum of the rally (or increasing support on a decline) is gradual, as opposed to the sudden halt to the continued advance (or decline) of prices following an exhaustion gap.

2. If trend before gap has already fulfilled measuring implications of price formation or consolidation area, gap is most likely exhaustion, not continuation (runaway). Continuation (runaway) gap is more likely if measuring implications are far short of being achieved.

3. First gap in runaway move is usually continuation, but each successive gap is more likely to be exhaustion gap, especially when the gap is wider than preceding gap.

4. On exhaustion gaps, activity (volume) is extraordinary during trading just after the gap forms, but previous price trend (rising prices or falling prices) doesn't keep pace with the day's high volume. E&M refer to "stickiness of prices" following an exhaustion gap.

5. Exhaustion rather than continuation gap is confirmed if a reversal develops on the day after the gap, carrying prices back to near the edge of the gap.

6. Unlike runaway gaps, which are usually not closed for some time, exhaustion gaps are closed quickly, usually within 2 to 5 days.

Implications: Signals halt in prevailing trend, and is usually followed by a pattern development, but should not be interpreted as reversal, necessarily. In nearly every case following an exhaustion gap a minor reaction or delay ensues before a new trend is established. For this reason, E&M suggest that traders close positions at once following an exhaustion gap until the direction of a new trend is determined.

E. Island Reversal

Definition: An island of prices in a compact trading range serving as a reversal, separated from a previous fast rally (or decline) by an exhaustion gap and from a subsequent fast decline (or rally) by a breakaway gap. The two gaps usually form at about the same level. The trading range is characterized by relatively high volume. If the trading range happens in just one day, the island is called a one-day reversal.

--Islands do not form as major reversals in and of themselves, but frequently appear within larger major or intermediate reversal patterns as in the head of a head-and-shoulders pattern. When they appear in minor patterns such as triangles or rectangles, they are more properly classified as common or pattern gaps.

--The reason for gaps forming at about the same place (before and after the island forms) becomes apparent when you realize that traders have no "vested interest" in the prices in the gap area. Prices can move more easily up and down through a range where no stock traded hands previously.

--The second gap (the breakaway that confirms the island) is sometimes closed by a quick pullback, but usually not.

Implications: Prices beyond the second gap frequently completely retrace the minor rally or decline preceding the island. The pattern is difficult to trade on (except for quick scalps) because of the speed of retracement.

F. Gaps in the Averages

-- Because the majority of stocks that make up an average must gap simultaneously to produce a gap in the average, gaps appear less frequently in the averages than in individual stocks.

-- Common or pattern gaps are rare, but breakaway or runaway gaps, though smaller as a rule, are not unusual. Exhaustion gaps and island reversals are rare in the averages.

-- Broader indexes show the fewest and smallest gaps. The volatile Dow Jones Industrial Average is a producer of frequent gaps.

Notes compiled by pup
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