Tuesday, January 10, 2017

Understanding Price Gaps

This article was written in 2007. 

Overnight closing on Wall Street, ground breaking news and surprising positive or negative announcements never fails to excite investors.  Stock prices responded by bursting into the perceived direction in an explosive manner as investors poured into the market.  This exuberant mood resulted in a vacuum between the last traded price and the previous.  In technical analysis, this vacuum in price is known as a price gap.  There are 3 types of price gaps worthy to look into and we shall study their characteristics and discuss how to trade them.
A gap occurs when the lowest price of a specific period is above than the highest level of the previous trading period.  The specific period can be that of a daily chart,  weekly chart or any other time frame.  The gap is represented by an empty vertical space between one trading period and another.  It can be formed by overnight good or bad news disseminated by the market.  A gap is considered “closed” when the price retraces the whole range of the gap.  By definition, all gaps will be closed.  However it is noted that while many gaps are closed within days or weeks, there are some which took months or years to close.  You can only imagine how much the price has to retrace to close a gap many months later.  Price gap is a result of irrational decision to buy or sell at any price  the equity is trading at and hence when rational thinking returns to the investors, they will start to unwind positions and thus lead to the closing of price gaps. Trading strategies can then be deployed in anticipation that the price will close the gap either partially or completely.
A breakaway gap is created when the price breakout from a chart pattern.  Generally, price gap symbolized the bullishness or bearishness of the breakout as per the direction.  It will be useful if we combine this analysis of breakout with volume confirmation.  Typically we would like to see breakout to the upside with heavy volume.  However, breakout to the downside does not require heavy volume.  

Figure 1: Breakaway Gap

In Figure 1, Aztech formed an ascending triangle price pattern which is bullish in nature.  It broke out of the price pattern accompanied by a price gap up.  As an ascending triangle is biased to the upside, the breakaway gap added more bullishness in the direction.  It must be noted that the volume accompanying the breakout is high as well.
A Continuation gap occurs during a sharp price movement in advance or decline.  This type of gap often occurs halfway between a previous breakout and the ultimate duration of the move.  It is normally accompanied with positive news and investors reacted to it in an exuberant manner. 

When a price contains more than one runaway gap, it indicates that the trend is very powerful.  However, market participants should be wary if there is a presence of a second or third gap as this is a sign that the move is likely to be out of steam soon.  There is a possibility that a second or third runaway gap may be the last one.  Hence an exhaustion gap is associated with the termination of a preceding move and is the last in a series of runaway gaps.  One good clue would be to look at the volume.  Exhaustion gap is normally accompanied with unusually high level of volume.  It is important to note that, exhaustion gap signals a likely price consolidation after the termination of a move and may not regarded as a major reversal.

Figure 2: Continuation Gap & Exhaustion Gap

As shown in Figure 2, after Genting International had been awarded the Sentosa IR project, investors reacted positively and price gaps up on 11th Dec 2006.  In the same month, stock price continues to gap up as investors continues to savor the happy occasion and great expectations from the news.  At the third gap up (exhaustion gap), it was observed that the volume was much higher.  Investors should be cautious by now as this is a warning of a potential exhaustion gap and price consolidation is a possibility.

 Figure 3: Continuation Gap with high volume

Osim as shown in figure 3 had a first gap down in late Oct 2006.  3 month later it had another gap down accompanied with unusually high volume.  It qualifies as an exhaustion gap as this is a second gap and since it comes with high volume.  Price then went into consolidation as what is expected from an exhaustion gap.  This consolidation lasted 3 months to late April before the price gaps down again.  

This article has discussed 3 types of price gaps and how we can use them to aid in our analysis.  Breakaway gap is most useful if there is a preceding price pattern.  Continuation gap which extends the preceding movement may lead to exhaustion gap which in turn may hint of price consolidation ahead.  Lastly, volume is a big clue in identifying an exhaustion gap.  

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This article first appeared in Smart Investor in 2007. 

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