|Gaps come in three forms, the breakaway gap, the exhaustion gap and the measuring gap. The breakaway gap tends to occur at the lower end of the market. The exhaustion gap tends to occur at the top of the market and the measuring gap occurs midway in the market. Looking at a chart, you have to decide which type of gap has occurred. If it is a breakaway gap, then the share price will move higher before correcting to fill the gap. If an exhaustion gap has occurred, then you can expect an island reversal to occur as the share price falls on a gap to fill the gap. If the gap is a measuring gap, then we know that the share price will continue rising and not necessarily fall to fill the gap, and should it fill the gap, then it offers a buying opportunity because the share price will rise. Looking at a chart therefore, you must always decide what type of gap has occurred.|
|Figure 1. Daily chart showing three gaps.|
|Graphic provided by: AdvancedGET.|
|Looking at the daily chart of Green Mountain Coffee (GMCR) in Figure 1, you see three gaps. Deciding what the gap was at the time it formed is not as easy as it appears to be. When gap 1 formed it was definitely a breakaway gap, because the share price was recovering from a stock price low of $21.50 in October 10, 2012. The RSI indicator was at overbought levels, suggesting a sell signal and that the share price could fall to fill the gap. Knowing that this was a breakaway gap, you knew that this need not necessarily occur, so you would have bought the share on a correction. |
Looking at gap 2 you would have expected the share price to fall to fill the gap, because the gap at that time looked as though it was an exhaustion gap. The share price did start to fall after it reached a high of $82.39 on May 20, 2013, and the share price did fall, but did not fill the gap, finding support on the upper gap level at $67.58 as shown at A. The RSI indicator gave a buy signal, and the share price rose to a new high of $89.69 by August 2013. This suggested that the gap was a measured gap, which means that you would expect the share price to rise to a target of $113.66 (67.5-21.50 = 46.08 + 67.58 = 113.66.). With the share price then falling and filling the gap by November 2013 as the RSI fell, you would have doubted the target suggested, but with support found on the lower gap level at $60.51, and with the RSI giving a divergence buy signal, you would have bought the share.
Finally, with gap 3 occurring after a strong rise in the share price from a low of $21.50 in October 2012 you would have known that this was an exhaustion gap, and that a fall in the share price to fill the gap was about to occur. When the RSI gave a sell signal on February 25, 2014 you would have sold at $121.37 as the share price fell. With the share price now filling the gap at $92.26, the present value, is it time to buy? The RSI is at oversold levels, but has not yet given a buy signal. Should you wait for the price to test the $84.22 level, the lower boundary of the gap?
|Figure 2. Daily chart showing suspect buy signal.|
|Graphic provided by: Omnitrader.|
|To look for a buy signal, I looked at the chart in Figure 2, an Omnitrader chart with a Vote line that gives me buy/sell signals based on the various strategies I have formulated. On April 16, 2014 the share price dropped below the upper gap line, and the Vote line suggested a buy signal based on the RSI 12-period strategy. Knowing that the gap that had formed was a exhaustion gap, I would have waited for more strategies to be added to a Vote line buy signal. Seven days later, on April 23, 2014 the share price fell strongly. The RSI Indicators and the TDIJak indicators have not given buy signals. |
With the share price filling the gap, and knowing that the gap that formed is an exhaustion gap, I would look at any future buy signal with suspicion, looking for a strong definite technical buy signal before buying the share.
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