Mind the gap! Technical Analysis by Darren Winters

A gap up or down in trading can be great news at the time, if it goes with you. What causes them is simply demand. If the market makers are inundated for buy-orders before trading starts, then the price will be adjusted upwards to ensure that they can find a sufficient number of sellers to balance the books. Likewise if the market makers have a lot of sell orders, they will drop the price to find enough buyers. Figure 1 shows a gap up, a gap down would simply be the opposite.



Due to it being demand that causes the gap, it is often seen as a bullish sign if moving upwards. It is not uncommon for the stock price to gap up a number of times over a short period, particularly if there is a series of news articles being released followed by an upgrade by broker. Figure 2 shows the same stock with a second gap coming about 9 days later.



THE TYPES OF GAP

A number of technical analysts have actually labelled these gaps as follows;

1st gap – Breakaway gap. This is an easy indicator to see and use. The success of using this is probably helped by so many other traders expecting a further move up. Whilst writing this article we decided to check this theory on the Dow Jones Industrial 30 (DJI 30). It showed us that in all but one stock, there was a continued move up for several days after the first gap. It also worked reasonably well with stocks moving down although it did leave us to believe that it may be linked with a rising market. Thus we would add some words of caution here, check out the trend of the overall market as well before stepping in with a trade.

2nd gap – Measured gap. This occurs in the middle of the trend, it is believed to give you the mid point of the total amount movement. Again we checked this theory with the DJI 30 and found that this worked within reason. The second move may be as much as 20% short and there was often a period of consolidation before continuing the trend. This was the case in the example shown in figure 2.

3rd gap – Exhaustion gap. This is often only recognisable after the stock trend had reversed. It is normally the smallest of the gaps and may have a slight reversal before hand. Certainly when back testing this theory we saw a drop off or a period of consolidation.

The Island reversal gap. This is often seen after any of the three above mentioned gaps. It is a bearish sigh if the stock had previously been trending up gapped and then reversed and gapped downwards as shown in figure 3. Alternatively it is a bullish sign if the stock has been trending down and reversed and gapped upwards.



MIND THE GAP

So why are we referring to ‘mind the gap’ if it looks like good news if we see one? Well in general, gaps get filled at some point in future. This may happen for a number of reasons, these may include;

1. Following a gap up, traders take the opportunity to take profits thus the stock closes the gap but may then continue it’s trend upwards.


2. Following a gap down, traders that have shorted the stock, close their positions taking profits.


3. The news that caused the gap, may soon be forgotten and the stock moves back to its longer term trend.


4. Then of course there are the brokers. If a stock gaps they would miss out on the opportunity of filling some orders. They get paid when they fill these orders so allowing the price to fall will ensure they get paid.

Wealth warning, not all gaps are closed immediately, if at all, so you will have to decide on when you take profits or loses if you are trading a stock that had gapped. They do not all act in the same way, e.g. you may get a breakout gap followed soon after by a Island reversal.

SOME EXAMPLES OF SOME RECENT GAPS

Using some stocks on our watch list and the DJI30, there are a number of stocks that have recently gapped. These include;

1. American Express (AXP), gapped down on 17th November, since then has moved back trying to close the gap. Intermediate trend down.


2. Eastman Kodak (EK), gapped down on the 17th then filled then gapped again on the 20th November. Intermediate trend consolidation.


3. General Electric (GE), gapped up on good news and broker upgrade on 18th then gapped up again and closed this gap on intraday trading on 19th November. Trend may be back on the way down to close the gap.

CONCLUSIONS

Trading on gaps can be profitable although needs time as things can change quite quickly, Look for the medium and long term trends as a guide to direction. As with any system it is best to paper trade this first, also ensure that you have your profit targets in mind and set stops.

Darren Winters