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Technical Analysis of Gaps: What Are Gaps?

Julie R. Dahlquist and Richard J. Bauer introduce their book, which provides a comprehensive study of gaps in an attempt to isolate gaps which present profitable trading strategies.
This chapter is from the book

Gaps have attracted the attention of market technicians since the earliest days of stock charting. A gap occurs when a security’s price jumps between two trading periods, skipping over certain prices. A gap creates a hole, or a void, on a price chart.

Because technical analysis has traditionally been an extremely visual practice, it is easy to understand why early technicians noticed gaps. Gaps are visually conspicuous on a price chart. Consider, for example, the stock chart for Huntington Bancshares (HBAN) in Figure 1.1. A quick glance at the price activity reveals four gaps.

Figure 1.1

Figure 1.1. Gaps on stock chart for HBAN September 29–December 2, 2011

Created with TradeStation

In Figure 1.1, Gap A and Gap C are known as a gap down. A gap down occurs when one day’s high is lower than the previous day’s low. In the figure you can see that the lowest price for HBAN on September 19 was $5.20. On September 20, the highest price at which HBAN traded was $5.01. Thus, a gap of 19 cents was formed. From September 19 through September 20, HBAN traded for $5.20 and higher and for $5.01 and lower; however, no shares traded hands at a price between $5.01 and $5.20. Thus, a void or gap in price was formed.

Just as a security’s price can gap down, it can gap up. A gap up occurs when one day’s low is greater than the previous day’s high. Both Gaps B and D in Figure 1.1 represent gap ups.

Early technicians did not pay attention to gaps simply because they were conspicuous and easy to spot on a stock chart. Because gaps show that a price has jumped, they may represent some significant change in what is happening with the stock and present a trading opportunity.

A technical analyst watches stock price behavior, searching for signs of any change in behavior. If a stock is in a strong uptrend, the analyst watches for any sign that the trend has ended. When a stock is in a consolidation period, the analyst watches for any sign of a change in behavior that would indicate a breakout either to the upside or to the downside. Spotting these changes leads to profitable trading, allowing the trader to jump on a trend, ride the trend, and exit once the trend has ended. Gaps can be one indication of an impending change in trend.

Given the persistence of superstitions, such as “a gap must be closed,” surprisingly little study has been undertaken to analyze the effectiveness of using gaps in trading. This book provides a comprehensive study of gaps in an attempt to isolate gaps which present profitable trading strategies.

Types of Gaps

Gap types differ based on the context in which they occur. Some price gaps are meaningful, and others can be disregarded.

Breakaway (or Breakout) Gaps

A breakaway gap is one that occurs at the beginning of a trend (see Figure 1.2). In November 2006, AT&T (T) was in a trading range. On November 29, the stock gapped up and an uptrend began. Because profits are made by jumping on and riding a trend, breakaway gaps are considered the most profitable gaps for trading purposes.

Figure 1.2

Figure 1.2. Breakaway gap on stock chart for T, November 13–December 14, 2006

Created with TradeStation

Runaway (or Measuring) Gaps

A gap that occurs along a trend line is called a runaway gap or a measuring gap. Often, a runaway gap appears in a strong trend that has few minor corrections. The contrast between a breakaway gap and a runaway gap is highlighted in Figure 1.3. In July 2006, Apple (AAPL) experienced a breakaway gap, with price jumping from $55 to $60 a share, and an uptrend began. The stock price headed higher over the next 3 months. Then, on October 19, the stock gapped up again by several dollars; the uptrend continued.

Figure 1.3

Figure 1.3. Runaway gap on stock chart for AAPL, June 23, 2006–January 24, 2007

Created with TradeStation

Runaway gaps are often referred to as measuring gaps because of their tendency to occur at about the middle of a price run. Indeed, this is what AAPL did in Figure 1.3. Thus, the distance from the beginning of the trend to the runaway gap can be projected above the gap to obtain a target price. Bulkowski (2010) finds that an upward runaway gap occurs, on average, 43% of the distance from the beginning of the trend to the eventual peak, and a downward gap occurs, on average, at 57% of the distance.

Exhaustion Gaps

As its name sounds, an exhaustion gap occurs at the end of a trend. In the case of an uptrend, price makes one last attempt to move higher on a last gasp of breath; however, the trend is exhausted, and the higher price cannot be sustained. For example, the gap up on January 9, 2007 (refer to Figure 1.3) occurs as AAPL’s powerful uptrend is coming to an end. It is easy to detect an exhaustion gap in hindsight; however, distinguishing an exhaustion gap from a runaway gap at the time of the gap can be difficult because the two share many characteristics.

Popular wisdom suggests that trading exhaustion gaps can be dangerous. An exhaustion gap signals the end of a trend. However, one of two things can happen; the trend may reverse immediately, or price may remain in a congestion area for some time. An exhaustion gap signals a trader to exit a position but does not necessarily signal the beginning of a new trend in the opposite position.

Other Gaps

In addition to breakaway, runaway, and exhaustion gaps, technical analysts identify a few types of gaps that are generally of no consequence for a trader. Common gaps occur in illiquid trading vehicles, are small in relation to the price of the vehicle, or appear in short-term trading data. An ex-dividend gap may occur in a stock price when a dividend is paid and the stock price is adjusted the following day. Ex-dividend gaps are insignificant, and the trader must be careful not to misinterpret them. Suspension gaps can occur in 24-hour futures trading when one market closes and another opens, especially if one market is electronic and the other is open outcry; these are also insignificant.

An opening gap occurs when the opening price for the day is outside the previous day’s range. After the opening, price might continue to move in the direction of the gap, forming a gap for the day. Or the price might retrace, closing the gap. Figure 1.4 shows three opening gaps for McDonald’s (MCD). See how, on December 2, MCD opened at a price higher than the December 1 price range. However, the price moved lower during the day, filling the gap, resulting in an overlap for the December 1 and December 2 bars.

Figure 1.4

Figure 1.4. Opening gap on stock chart for MCD, November 29–December 14, 2011

Created with TradeStation

Of course, any gap begins as an opening gap. On November 30 and December 8, MCD had an opening gap to the upside, and the price never retraced enough on those days to fill the gap. Throughout this book, when we use the term “gap” we are referring to instances in which the gap is not filled within the trading session unless we directly specify that we are discussing opening gaps.

Some traders watch for trading opportunities with opening gaps. General wisdom suggests that if a gap is not filled within the first half hour, the odds of the trend continuing in the direction of the gap increase. Figure 1.4 showed an opening gap on December 2 and on December 5 for MCD. Figure 1.5 shows how quickly these opening gaps were closed by considering intraday data and using 5-minute bars. On December 2, for example, the opening was filled on the fifth 5-minute bar, or within 25 minutes of the open. On December 5, the opening gap was filled within the first 5 minutes of trading.

Figure 1.5

Figure 1.5. Open gaps filled on intraday stock chart for MCD, December 1–5, 2011

Created with TradeStation

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