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.
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.
DISCLAIMER: The contents in this website are for fun reading and must not be taken as a buy or sell advice. You must do your own analysis on top of my postings. By reading this blog, you agreed that i am not responsible for your trading.
