Gaps

06/19/01 01:04:13 PM

by Dennis D. Peterson

Some are commonplace and mean little, while others are less frequent but meaningful.

Security: PGR
Position: N/A

Gaps are changes in price that occur in the absence of trading. Price suddenly takes a jump up (or down). Understanding what a gap might mean in terms of future prices means looking at the volume associated with the gap and most importantly, what were the circumstances under which the gap occurred.

Gaps occur between the close and next open of the market. A gap at the open may get filled during the day and trading opening gaps is a separate subject. Opening gaps that get filled could be the device of a specialist or market maker who intends to fade the open for a quick profit. What this article covers are those gaps in which there is no overlap with the entire OHLC bars between successive trading days.

Day-traders typically close out all of their positions rather than be vulnerable to what might happen on the open of the next morning. Why do gaps occur? Companies have a habit of announcing their earnings after market close. The government often releases economic news before market open. There are some exceptions, such as Federal Reserve monetary policy changes, but much news is released while the market is closed, or at least after normal trading hours. Gaps can also occur because prices have risen above, or fallen below, investors comfort level, independent of any economic news.

You may have heard that all gaps get filled. The more accurate statement is that most gaps get filled sooner or later, where later can be years. Sooner can be days. What matters is figuring out what type of gap has occurred and what it might portend in terms of support or resistance. As to whether a gap always get filled, ask yourself, %93if Microsoft had a common gap five years ago when it sold for a fraction of what it does today - do you expect that Microsoft will ever get down to the prices of say five years ago (check 3/13/96 gap) and fill the gap?%94 Some types of gaps will not be filled or only partially filled.

There are five types of gaps: common, breakaway, runaway, exhaustion, and island reversals.

Common gaps are those that are seen within a previous price range, particularly within consolidations. Most importantly common gaps are not accompanied by an increase in volume. Common gaps say little about support and resistance. They can be nothing more than the result of a bear or bull trap (see posting on %93Pivots%94, 12/20/00).

Breakaway gaps do provide information about support and resistance levels. What distinguishes them is a sudden increase in volume. Breakaways can occur either to the upside or downside. Breakaways occur at the end of significant patterns. A significant pattern could be a consolidation pattern or a trend. The lack of a breakaway at the end of a consolidation pattern means the pattern is less likely to act as a continuation pattern. A breakaway gap at the end of a consolidation pattern increases the odds enormously that the consolidation is a continuation of the trend.

Breakaway gaps are important events because they establish resistance or support levels. If it is a downside breakaway, then those who have long positions above the breakaway are likely to sell if prices rise again and form resistance to any recovery of price. Those who bought after the downside breakaway will hold to make a profit and will form support if prices recover. If it is an upside breakaway just the opposite is true. Those who were long prior to the upside breakaway are seeing some nice profits for their long positions and form the last line of support, but so will those who bought after the breakout.

Runaway gaps are continuations of a strong move up or down. They are sometimes referred to as measuring gaps because they often measure the halfway point to either a pivot point or consolidation pattern. Since a consolidation pattern is a sideways movement, the halfway measurement could be just to the middle of the sideways movement of the consolidation (see example below). Since most bottoms and tops are complex formations, often Ws or Ms or consolidations (which is a series of Ws or Ms), taking a position before the formation has resolved is a bit risky. Runaway gap volume is typically strong, but some authors allow for moderate volume.

Exhaustion gaps can occur on upside or downside moves. They are the last attempt at a higher (or lower) price. Unlike breakaway gaps, which take place at the end of a significant pattern, exhaustion gaps occur just before a top or bottom. Exhaustion gaps also have high volume. They do not in general portend a trend change, but more likely a consolidation period to follow. Downside exhaustion usually sees a dead cat bounce as a follow-on event.

Island reversals are periods of price activity, usually characterized by a narrow trading range, that are started by an exhaustion gap and completed with a breakaway gap. This price activity, isolated by gaps on both sides, can last a few days or few weeks. What's important is that island reversals mean that price trend is going to move in an opposite direction from the way price entered this period of isolated activity. Since exhaustion and breakaway are identified by increased volume, this pattern is a dead give away of what is going to come.

Figure 1: PGR daily price and volume (bottom chart) from April 1998 through February 1999, Relative Strength Index of PGR for same period as bottom chart (middle chart), and PGR daily price and volume for the last four years (top chart).

Graphic provided by: MetaStock.

Graphic provided by: Data vendor: eSignal<.

Progressive Corporation (PGR: NYSE) is the poster child for gaps. Owning this stock must be exciting. Moving from left to right on the bottom price chart the following events occurred:

1. An uptrend, which was initially broken, then a breakaway gap. Line B identifies what will later become a support level. The upper part of the gap will later on act as resistance and can be seen on the right just above line B.

You might ask, "Is there a way that I might have seen this first breakaway gap?" I have found that the Relative Strength Index (RSI) is especially useful at tops. When you compare the bottom chart price trend (identified in green) with the middle chart of RSI, you see that RSI had an isolated peak - resulting in a momentum downtrend from the RSI peak in mid-May to the lower peak at the end of June. The RSI momentum downtrend diverges from the PGR price uptrend. This suggests that prices went up based on scarcity. The volume supports that contention.

2. After the breakaway gap a runaway gap occurs. Remembering that runaway gaps are also called measuring gaps and that they mark the halfway point, I can estimate where the bottom might occur - remember a bottom can be a complex pattern such as consolidation pattern. The difference between the top on 7/14, with a close of 155 and the runaway gap on 7/27 of 129 is 26. Using 129 as the midpoint says the bottom should be around 103. While the lowest close was at 97, 103 is a reasonable choice for an average of the sideways move that took place at the beginning of September.

3. After the runaway gap and a period of consolidation at the beginning of September, a common gap occurs. You might want to argue that since price continues on up for a week afterwards that I should identify the gap as a breakaway. It's because the volume did not jump up, that I have a problem with doing that. Without the volume the gap will have a difficult time providing either support or resistance for follow-on price moves.

4. In mid-October an upside breakaway gap occurs. You will notice that price busts on through the level established by the swing point in late September - which says that this will be a strong move to the upside. The move up through November is marked by support and resistance, first seen briefly at level A of the runaway gap and then more obviously by the downside breakaway gap that occurred in July.

5. The next gap I have identified is an exhaustion gap in January - there was another common gap on December 17. This was a difficult call on my part - because I can see strong arguments for this being called a downside breakaway gap. I think that if you were watching this without the benefit of hindsight you would be throwing up your hands at this point and flipping a coin to make the call.

What persuaded me to call this exhaustion were two items. First, prices had already started a convincing downtrend by the beginning of January. Second, and this is hindsight, if this were a breakaway gap then I would expect the downtrend to continue well past the point where they turned back up at the beginning of February. As an aside, RSI didn't have a negative divergence when this exhaustion gap occurred. It looks as though momentum hit a peak, and buying ran out of gas. If you go through a volume analysis of price activity in November and December you will find that there is little support for the peak on 1/12/99.

6. The next event I have identified is an island reversal (see top chart of Figure 1). This strongly convinced me, that the gap in January was an exhaustion gap, because clearly the price behavior is a classic island reversal pattern. If you thought prices had taken a serious tumble in 1998, you hadn't seen anything yet.

Were there any other clues as to what was going to happen to PGR in 1998? This is the same stock I analyzed using Gann and Fibonacci (see "Gann and Fibonacci (Part I of III)", 4/2/2001).

Dennis D. Peterson

Market index trading on a daily basis.

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