Gaps: A Common Pattern

06/13/05 08:02:20 AM

by Paolo Pezzutti

This short-term pattern provides good trading opportunities.

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Many daytraders and short-term traders fear the opening gap so much that it is their primary motivation not to carry positions overnight. Robert Edwards and John Magee popularized gaps 50 years ago in their book Technical Analysis Of Stocks Trends. Commonly, in technical analysis textbooks you will find a chapter dedicated to gaps. They are often perceived as a risk, but they can also be an opportunity for profit. A gap day is one in which the low is higher than the previous day's high or the high is below the previous day's low. Typically, analysts refer to gaps that take place from one day's trading to the next. However, gaps may also occur during other time frames.

Traditionally, there are four types of gaps:

- Common gap: It occurs in a trading range and is not significant. They are filled very often, as they are not caused by exceptional changes in the market or its underlying supply and demand conditions.
- Breakaway gap: It occurs when prices climb above a trading range, leaving a blank area in which no trading activity has occurred. It appears as a market breaks out into a new trend move.
- Continuation gap: It occurs when a trend accelerates. This gap is called also a runaway or measuring gap, so-called because, in theory, the expected price movement is supposed to be roughly equivalent to the part of the trend that occurred prior to the gap. During a trend, you may see a series of continuation gaps in the chart.
- Exhaustion gap: It occurs after an extended trend and is soon followed by a trend reversal. The market opens higher and rallies, just for that day or a few days. Volume is high, but it could not be as high as during prior moves. In addition, the assets could have some oscillator divergences.

These gaps have fairly different characteristics, and traders have to learn the various tactics to deal with them. Prices, other than noise, will not significantly change until some new perception of the future value of the stock or commodity enters the marketplace. During the hours when markets are closed, political and economic events unfold that will affect the future value of assets. These events are factored into the price when markets open. International markets may move in one direction, and when the US market opens, prices might gap in that same direction. In addition, a deceptive move could have been orchestrated to have a high/low open.

Figure 1: In the QQQQ chart, you can see gaps in a downtrend from December 2004 to May 2005.

Graphic provided by: TradeStation.

In Figure 1, you can see the daily QQQQ chart. On December 17, 2004, after a previous high retest, prices printed the first gap, with an impulse to the downside. Something was changing in the market attitude. Afterward, the gap revealed itself a breakaway gap. In fact, after a pullback with much lower volume that filled the gap opened a few days before, prices moved again down very fast. The breakaway gap was the beginning of a new downtrend. On January 20, 2005, you can see a typical continuation gap. Even if this gap was filled 18 days later, the market, after a consolidation that ended up as a distribution period, moved again, confirming the ongoing downtrend. In April, the third gap in the downtrend happened to be the typical exhaustion gap. Four days later, the gap was filled once again, but prices managed to print a new low on April 15 with a spike that signaled the end of the downtrend. After printing the hammer, prices started moving higher in an impressive long series of positive sessions.

Statistically, gaps are filled more often than not. Fading the gap is a trading strategy, which is used with many different variations. If the gap is filled for the day and prices move back into their prior trading range, then it may be seen as a failure for the news to take hold and could represent a reason for reversal.

If you look for high-probability trades, fading gaps (perhaps even a partial fill) can be part of your set of short-term strategies. The action should be completed very soon. Prices should start the fading action in a few bars. A protecting stop should also be in place. If you want to increase further your probabilities for a winning trade, you can fade only small gaps or even opening gaps within the previous day's range. However, increasing winning probabilities reduces the average profit, and commissions erode gains. It is a tradeoff that must be accurately evaluated.

Unfilled gaps often open the way to powerful trend days. They do not happen often, but they bring very good profits. Gap size, volume, important news, preopen volumes, sector analysis, other indexes' behavior, and market conditions (trend congestion) are some of the elements that can be taken into account trying to figure out the outcome of a gap. You want to profit from fading or betting on the continuation in the gap direction.

Paolo Pezzutti

He is the author of the book "Trading the US Markets - A Comprehensive Guide to US Markets for International Traders and Investors" - Harriman House (July 2008)