GAPS are a part of every trader's life and as long as traders react to events and news from companies in emotional ways, gaps will continue to be a feature of most stock charts.
Knowing how to interpret and handle these gaps may ensure more effective trading and even peace of mind when the hollow voids between closing and opening prices appear.
Gaps are classified according to the position in which they appear in relation to the price movement or pattern.
Breakaway gaps:
Firstly, we will discuss Breakaway gaps. These occur after a period of price consolidation or other sideways patterns such as triangles. The breakaway gap causes a clear breakaway from the price pattern through the support or resistance lines.
Using breakaway gaps:
Breakaway gaps often indicate the start of a new direction in price movement, but the direction may be unclear at first, as retracements may occur close to the previous support or resistance line broken by the gap.
Using other indicators for confirmation is helpful at this time to profit from this new trend that was most likely caused by professional traders (rather than amateurs' emotional trading effects on the price) before this new trade opportunity is missed.
Runaway gaps:
The second type of gap is a runaway gap. Also referred to as continuation or measuring gaps, these gaps occur when the majority of the market's sentiment continues strongly in its current opinion and then drives the price rapidly in the same direction as the current dominant trend.
Therefore, we see a gap in the direction of the dominant rally or decline. These gaps are also most likely found in the third wave where rapid price movement is witnessed.
Using runaway gaps:
These gaps are very useful in predicting the potential target of the current trend in which they occur as they can be used as a measuring tool.
Simply take the measurement from the beginning of the trend to the beginning of the runaway gap and then project this measurement from the end of the runaway gap to obtain the possible target of the price in the same direction.
This allows the trader to make calculated price prediction. A pull-back or retracement is expected later on, but the predicted "closing of the gap" may not occur as immediately as believed by some.
Exhaustion gaps:
Lastly, we look at exhaustion gaps. Like runaway gaps, exhaustion gaps also occur in the direction of the current trend, but are positioned near the end of the current price action.
This indicates a final boost in the prevailing sentiment before a trend reversal occurs. We can gather that these gaps are mostly caused by amateur traders who are afraid to miss out on the current price move and so they get rush into the trade too late, when the professional traders are getting ready to exit their trades.
Using gaps on intraday Charts:
It is wise to wait for confirmation that of the trend reversal as indicated by the exhaustion gaps before taking the opportunity to enter in the correct trend direction.
This helps to separate oneself from the amateur traders by remaining analytical and not getting emotionally involved in trading a trend that is in fact on its way to reversal.
The question now arises if we can apply this knowledge of gaps only on daily charts or can we also apply it on intraday charts?
It goes without saying that daily charts are more reliable in technical analysis than hourly or five minute charts. There are far less false signals and positions can be entered with more confidence.
But many of us do use shorter period charts as an aid in combination with daily charts to enter positions. Let's look at such an example where we use an hourly chart of the Alsi40 Index.
What should we notice here?
Firstly we see the measurement gap that appeared on the midpoint of the 2 000 point advance. Secondly we notice the exhaustion gap that appeared on Monday morning (July 27) when the markets opened.
This in all probability was a signal that the advance is over for now and that the trend has exhausted.
We hope that the discussion of gaps prove useful to you in your trading endeavours. We will be discussing these strategies and many other trading strategies in our day long Introductory Market Analysis Course that is scheduled for Thursday August 27 and Saturday September 5.
- Fin24