Issuu on Google+

4366_23.qxd

2/23/05

11:51 AM

Page 362

23 Gaps G

RESULTS SNAPSHOT Upward Breakouts Appearance

A price gap appears when the current low is higher than the prior high.

Reversal or continuation

Short-term bullish continuation

Performance rank

Not applicable

Close Within a Week

Bull Market

Bear Market

Area gap

89%

93%

Breakaway

2%

9%

Continuation

4%

20%

Exhaustion

61%

78%

Surprising findings

The largest gaps occur in bear markets. Bull market gaps do well when they appear near the yearly high. Large gaps perform better than small ones.

Downward Breakouts Appearance

A price gap appears when the current high is below the prior low.

Reversal or continuation

Short-term bearish continuation

Performance rank

Not applicable

362


4366_23.qxd

2/23/05

11:51 AM

Page 363

Tour Close Within a Week

Bull Market

Bear Market

Area gap

92%

89%

Breakaway

1%

1%

Continuation

9%

13%

Exhaustion

64%

63%

Surprising findings

363

Same as for upward breakouts

There are five types of gaps, four of which I review in this chapter. The remaining gap, the ex-dividend gap, is not considered because it rarely happens and has no investment significance. The ex-dividend gap usually occurs in utility stocks or stocks with high-paying dividends. On the day of dividend distribution, the price sometimes moves downward leaving a gap in the price chart. Even though the price of the stock after distribution reduces by the dividend amount, the day’s trading range often fills the gap so no actual gap appears on the chart. I define closing the gap to be when prices return and span the gap completely. The area gap closes quickest, with nearly 90% of those gaps closing within a week. Listed in the Results Snapshot table is the average time it takes price to close the gap. Sometimes gaps close quickly (such as exhaustion gaps) because they are found near the ends of trends where price reverses and fills the gap. Other gaps take much longer since they mark the start of a strong trend (breakaway gap). The continuation gap is a combination of the two because it commonly appears in the middle of trends. Gaps had a few surprises. I found that larger gaps appear in bear markets for some reason. Performance improves for gaps in bull markets when they appear near the yearly high. Finally, large gaps perform better than small ones.

Tour A gap appears in an uptrend price series when yesterday’s daily high is below today’s low price. A downtrend gap is similar, being created when yesterday’s low is above today’s high. In both cases, some type of exuberance is driving the stock to create a gap. It sometimes is nothing more than the stock being worth less simply because of a dividend distribution. At other times, the repercussions are more severe. An earnings surprise, either positive or negative, often causes a gap and the stock to rise by 10% or 15% or to decline by 30% or more, depending on the severity of the news. Figure 23.1 shows a plethora of different gap types. Area gaps occur in congestion zones, usually when prices are moving sideways. Price gaps up or down and the gaps close quickly. Of all the gap types, area gaps are common, appearing all over the place. Breakaway gaps appear at the start of trends. They, too, are quite numerous and accompany high volume. Usually there is some fundamental event driving the stock, creating a breakaway gap. Continuation


4366_23.qxd

2/23/05

364

11:51 AM

Page 364

Gaps Acuson Corp. (Medical Supplies, NYSE, ACN)

– 21 – 20 – 19

Exhaustion

– 18 Continuation

– 17

Breakaway

Area Gap

– 16 Continuation – 15

Area Gap

– 14 – 13

Uptrend

– 12 – 11

Jan 96

Feb

Mar

Apr

May

Jun

– 10 Jul

Figure 23.1 Plenty of gaps appear in a daily price chart. The most numerous are the area gaps.

gaps are relatively rare because they appear in the middle of strong trends. Those trends themselves do not occur very often and even less often do they contain a gap. Exhaustion gaps signal the end of trends. They are the last jump up or down before the trend either reverses or moves sideways.

Identification Guidelines Table 23.1 lists identification guidelines for gaps. Area gaps. Area, common, or pattern gaps are all names for the same type of gap. The gap forms inside or just after a consolidation region. It is easy to spot as prices seem to hook around and close the gap in less than a week (many times in the next trading session). Figure 23.2 shows many examples of this hook feature: For example, you can see in late March that prices gap down and the next day the high closes the area gap. A quick hook such as that is characteristic of area gaps. Usually, few or no new highs (for uptrends) or lows (when price gaps lower) occur immediately after the gap. Volume may be high on the day price gaps but usually settles down quickly. You can see this behavior in late January. Volume spikes on the gap day then returns to normal the next day. Breakaway gap. Breakaway gaps highlight the start of a new trend. Volume rises substantially above the prior day and price gaps upward and continues rising (or falling in the case of a descending price gap) forming new highs (or lows). Consider the breakaway gap in early January shown in Figure 23.2. You can see prices moving up for 3 days, surroundings the gap, accompanied by a


4366_23.qxd

2/23/05

11:51 AM

Page 365

365

Identification Guidelines Table 23.1 Identification Characteristics Gap Type

Discussion

Area, common, or pattern

Occurs in areas of congestion (trendless markets) and closes rapidly. Volume on the day of the gap may be high but returns to normal in a day or two. No new highs (uptrends) or lows (in downtrends) occur after the gap. A distinctive curl as the gap closes is a key indication of this gap type.

Breakaway

Identifies the start of a new trend and usually occurs after breakout from a consolidation region. Is accompanied by high volume on the day of the gap, which continues for several days. The trend continues long enough for several new highs (for uptrends) or new lows (downtrends) to occur after the gap.

Continuation measuring, or runaway

Happens in the midst of a straight-line advance or decline. Prices continue making new highs or lows without filling the gap. Volume is usually high, propelling prices in the direction of the trend.

Ex-dividend

Is triggered by a dividend distribution. Prices move down by the amount of the dividend and a gap appears if the day’s trading range does not close it.

Exhaustion

Occurs at the end of a trend on high volume. The gap is not followed by new highs or lows and the gap itself may be unusually wide. After the gap, prices enter a consolidation region or reverse. Commonly occurs after a continuation gap. The gap closes quickly, usually within a week.

Advanced Micro Devices, Inc. (Semiconductor, NYSE, AMD) Area Exhaustion

Island Reversal

Continuation Breakaway

Breakaway Exhaustion

Area Breakaway

Area Area

Breakaway

Area Area Breakaway

Jan 93

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

– 33 – 32 – 31 – 30 – 29 – 28 – 27 – 26 – 25 – 24 – 23 – 22 – 21 – 20 – 19 – 18 – 17 – 16 – 15 – 14 – 13 – 12 – 11 – 10 Oct

Figure 23.2 Various gap types with area gaps illustrating the hook feature. Volume pattern and position within the trend are the main keys to identify correctly the different gap types.


4366_23.qxd

2/23/05

366

11:51 AM

Page 366

Gaps

rising volume trend. Then prices level out and move horizontally for several weeks before gapping down in an area gap. Two days later, another breakaway gap (not labeled on the chart) appears and prices reach new daily highs for 3 days in a row before settling back. The large breakaway gap in mid-April, accompanied by a high volume spike, is not an exhaustion gap because price continues rising. The June breakaway gap begins after a minor congestion area but the gap could be a continuation (gap) of the downward price move of a week earlier. Volume spikes upward as price makes a large gap. Usually large gaps are associated with exhaustion gaps, but prices continue moving lower after just a few days. Continuation gaps. Continuation gaps occur in the middle of price trends. They do not happen often since it takes a sharp rise followed by a gap and a continued rise in the stock (the reverse for downtrends, too). In Figure 23.2, you can see two continuation gaps in August when prices zoom from a low of 23.50 to 32.63 in about 2 weeks. The gaps appear in the quick, sharp price rise on high, but not unusually high, volume. The quick rise forms new highs and the gap remains open (compare these continuation gaps with how quickly the area gap closes). Of course, in a downtrend, prices gap downward and form new lows. Ex-dividend gaps. An ex-dividend gap appears on the price chart when a dividend-paying stock distributes the dividend. Usually, however, the normal trading range will cover the gap. Exhaustion gaps. Exhaustion gaps commonly follow continuation gaps. The highest gap in the August uptrend is an exhaustion gap. At first I thought it was another continuation gap, but the gap is slightly larger than normal and prices pause for 2 days before making new highs. Those are some key factors associated with exhaustion gaps. Excessively wide gaps are most likely exhaustion gaps when they appear near the end of a trend. Two exhaustion gaps appear on the chart, one in August and one in September. The September gap closes quickly, which is typical for exhaustion gaps. Most exhaustion gaps occur on high volume; it is like the last gasp before prices end the trend. You can see in Figure 23.2 that both exhaustion gaps have high volume, but the September one takes the cake. Volume spikes upward even as prices descend, then volume recedes but remains high for several days after the gap. The high volume highlights the struggle of investors who want to purchase the stock at a good price with those who are trying to get out of the situation at the best offer.

Statistics: Area Gaps Table 23.2 shows general statistics for area gaps. Number of formations. I found 484 area gaps in 97 stocks from mid1991 to early 2004, but I did not cover all years in between. Since I was looking for the time to close the gap, I found little need for additional samples.


4366_23.qxd

2/23/05

11:51 AM

Page 367

367

Statistics: Breakaway Gaps Table 23.2 General Statistics

Description

Bull Market, Up Breakout

Bear Market, Up Breakout

Bull Market, Down Breakout

Bear Market, Down Breakout

Number of formations

127

154

127

76

Average time to close the gap

3 days

3 days

3 days

3 days

Closed in 1 week

89%

93%

92%

89%

Closed in 2 weeks

99%

100%

100%

100%

Closed in 3 weeks

100%

100%

100%

100%

Average gap size

$0.31

$0.55

$0.28

$0.59

Average time to close the gap. On average, it takes just 3 days for price to cover the gap, regardless of market condition or breakout direction. Percentage closed. The table shows the closure rates. Nearly all of the area gaps close in the first week, and those in a bull market with an upward breakout hold out the longest by closing within 3 weeks. Average gap size. In all four gap types, the largest average gap size occurs in a bear market. Why this is the case is a mystery to me. The smallest gaps occur in a bull market, usually with an upward breakout, but not with area gaps (which has the smallest average gap associated with downward breakouts).

Statistics: Breakaway Gaps Table 23.3 shows general statistics for breakaway gaps. Number of formations. I used 132 stocks to find 737 breakaway gaps. That high number of gaps in a small sample set shows how often these formations occur. Average time to close the gap. The average time for the gap to close varies from about 2 months (61 days, bear market, up breakout) to nearly 6 months (168 days, bull market, down breakout). Percentage closed. Breakaway gaps do not close quickly, as Table 23.3 shows. Even after a year, some gaps remain open. Average gap size. The average gap size varied across market conditions and breakout directions, with bear market gaps being larger than bull market ones, and gaps in a bear market with a downward breakout being the largest of all. Yearly position. Since breakaway gaps are important to traders, I checked their position over the yearly trading range. Bull markets showed the most gaps within a third of the yearly high. Bear markets had more gaps in the middle of the yearly trading range.


4366_23.qxd

2/23/05

368

11:51 AM

Page 368

Gaps Table 23.3 General Statistics

Description

Bull Market, Up Breakout

Bear Market, Up Breakout

Bull Market, Down Breakout

Bear Market, Down Breakout

Number of formations

345

92

226

74

Average time to close the gap

136 days

61 days

168 days

111 days

Closed in 1 week

2%

9%

1%

1%

Closed in 2 weeks

9%

22%

6%

15%

Closed in 3 weeks

18%

38%

11%

35%

Closed in 1 month

23%

45%

17%

38%

Closed in 2 months

39%

62%

38%

53%

Closed in 3 months

46%

73%

46%

55%

Closed in 6 months

56%

87%

64%

62%

Closed in 1 year

66%

95%

75%

70%

Average gap size

$0.43

$0.85

$0.68

$1.38

Percentage of breakouts occurring near the 12-month low (L), center (C), or high (H)

L24%, C25%, H51%

L33%, C41%, H26%

L24%, C30%, H46%

L35%, C41%, H24%

Percentage rise/decline for each 12-month lookback period

L38%, C35%, H41%

L36%, C30%, H29%a

L19%, C18%, H20%

L29%a, C29%, H29%a

Small gap size performance

35%

27%

–19%

–25%

Large gap size performance

41%

35%

–19%

–32%

Median gap size

$0.27

$0.59

$0.38

$0.62

Note: Minus sign means decline. a

Fewer than 30 samples.

Yearly position, performance. Gaps in bull markets performed best when the gap was near the yearly high. Gaps in bear markets did well near the yearly low, but the sample size in a down market obscured the results. Gap size. Do large gaps perform better than small ones? Yes. I found the median gap size and compared all gaps to the median. Those larger than the median performed as well or better than did those smaller than the median. If you want to trade a breakaway gap, check to see if it is larger or smaller than the median listed in Table 23.3. That may be an indication of performance.


4366_23.qxd

2/23/05

11:51 AM

Page 369

369

Statistics: Continuation Gaps

Statistics: Continuation Gaps Table 23.4 shows general statistics for continuation gaps. Number of formations. I used 173 stocks to find 495 continuation gaps from mid-1991 to early 2004, but I did not search the entire period. I split the period from 1991 to 1996 and 1999 to 2004, the latter period to encompass a bear market. Average time to close the gap. Compared to breakaway gaps, continuation gaps close quicker, as one might guess (because breakaway gaps appear near the trend start but continuation gaps appear in the middle). The longest (bull market, up breakout) takes just over 3 months to close, on average. Percentage closed. Continuation gaps in a bear market with an upward breakout close quickest as do downward breakouts in a bear market. Average gap size. Gaps in a bear market with downward breakouts show the largest size. If the general market helps the gap size grow, then I would expect gaps in a bull market with an upward breakout to show a large size. That is not the case. Bear market gaps are bigger than bull market ones.

Table 23.4 General Statistics

Description

Bull Market, Up Breakout

Bear Market, Up Breakout

Bull Market, Down Breakout

Bear Market, Down Breakout

Number of formations

168

83

122

122

Average time to close the gap

98 days

43 days

77 days

91 days

Closed in 1 week

4%

20%

9%

13%

Closed in 2 weeks

20%

39%

23%

27%

Closed in 3 weeks

29%

57%

39%

36%

Closed in 1 month

35%

58%

52%

47%

Closed in 2 months

55%

80%

64%

60%

Closed in 3 months

61%

86%

75%

66%

Closed in 6 months

71%

93%

90%

75%

Closed in 1 year

80%

95%

93%

81%

Average gap size

$0.47

$0.86

$0.48

$1.24

Position of gap in time trend (trend start to gap start)

50%

55%

69%

72%

Position of gap in price trend (trend start to gap center)

43%

48%

57%

52%


4366_23.qxd

2/23/05

370

11:51 AM

Page 370

Gaps

Gap position. The position of the gap in the time trend varies with breakout direction. Those gaps with upward breakouts seem to appear near the middle of the trend (50% or 55% of the way to trend end). Those with downward breakouts happen almost three-quarters of the distance to the end. On a price basis, gaps appear near the midway point. Those with upward breakouts are slightly short of the midway point (meaning the rise is higher after the gap). Those in a bear market are slightly longer—the decline is shorter after the gap.

Statistics: Exhaustion Gaps Table 23.5 shows general statistics for exhaustion gaps. Number of formations. I used 173 stocks to find 471 exhaustion gaps. That finding suggests exhaustion gaps are plentiful. Average time to close the gap. Exhaustion gaps close quickly, usually between 1 and 2 weeks, on average. Percentage closed. The table shows how quickly exhaustion gaps close. In one week, about two-thirds of the exhaustion gaps close. In two weeks, almost all of them are closed except for downward breakouts in a bull market, which have 22% still open. Average gap size. The average gap size varies, with the largest appearing in a bear market with a downward breakout. The 94-cent wide gap is almost twice the size of the bull market, up breakout gap.

Table 23.5 General Statistics

Description

Bull Market, Up Breakout

Bear Market, Up Breakout

Bull Market, Down Breakout

Bear Market, Down Breakout

Number of formations

120

111

129

111

Average time to close the gap

9 days

7 days

14 days

10 days

Closed in 1 week

61%

78%

64%

63%

Closed in 2 weeks

91%

90%

78%

85%

Closed in 3 weeks

93%

94%

87%

92%

Closed in 1 month

98%

95%

90%

95%

Closed in 2 months

100%

99%

95%

96%

Closed in 3 months

100%

100%

97%

96%

Closed in 6 months

100%

100%

98%

99%

Closed in 1 year

100%

100%

100%

99%

Average gap size

$0.49

$0.79

$0.63

$0.94


4366_23.qxd

2/23/05

11:51 AM

Page 371

Trading Tactics and Sample Trade

371

Trading Tactics and Sample Trade Table 23.6 lists trading tactics for gaps. To successfully trade gaps you have to be quick, making sure to use stops, and you have to be ready to close out a trade at a moment’s notice. Still, they can be profitable. Consider what Gina did with the situation shown in Figure 23.3. As a seasoned investor, Gina knew all about gaps and practiced trading them on paper until she was successful most of the time. The practice honed her skills and pulling the trigger seemed rote. With a focus on limiting her losses, she was growing confident that her trading style was one that would allow her to succeed in the markets, so she took the leap and decided to trade her system for real. She followed the stock for a long time and was both familiar and comfortable with the fundamentals of the company. When she noticed the breakaway gap occur on May 10, she quickly checked the identification guidelines. Volume was above average (although it may not be clear from the chart) and a new upward price trend seemed to be forming. She called her broker and bought 1,000 shares receiving a fill at 58 that day. She placed a stop-loss order at 57, 0.13 below the lower gap rim just to be safe. If this turned out to be an area gap, she would probably be stopped out for a small loss. During her paper trading days, she discovered that most gaps provide near-term support or resistance, so she was confident that her stop would hold. Table 23.6 Trading Tactics Trading Tactic

Explanation

Area gaps

These gaps are too short-lived to be traded profitably, consistently.

Breakaway gaps

If high volume is present at the start of a trend, then trade with the trend. Verify gap type by reviewing the identification guidelines before trading.

Continuation gaps

Continuation gaps usually mark the halfway point so you can gauge the eventual price move. Measure from the trend start to the gap center and project the difference from the gap center to the predicted high or low.

Exhaustion gaps

If an abnormally wide gap occurs or a gap occurs at the end of a trend, then close out your position when the trend reverses. After a trend reversal, consider trading the new trend (shorting the stock if the prior trend was up). Violent reversals often follow exhaustion gaps. Close out the trade the day after new highs (for uptrends) or new lows (downtrends) fail to occur.

Stop loss

The lower rim (for uptrends) or the higher rim (for downtrends) of a gap is a good place to put a stop (0.15 or so away from the rim). Gaps provide near-term support or resistance, so this strategy works well with those gaps that do not close quickly.


4366_23.qxd

2/23/05

372

11:51 AM

Page 372

Gaps Alco Standard Corp. (Office Equipment & Supplies, NYSE, ASN) Possible One-Day Reversal Support Exhaustion (E) Continuation (C) Breakaway (B) Exhaustion A

B Apr 96

May

CE Jun

– 66 – 65 – 64 – 63 – 62 – 61 – 60 – 59 – 58 – 57 – 56 – 55 – 54 – 53 – 52 – 51 – 50 – 49 – 48 – 47 – 46 – 45 – 44 – 43 – 42 – 41 – 40 Jul

Figure 23.3 Gina bought the stock on the breakaway gap and sold it a few days later for a $7,500 profit. Then she shorted the stock as the exhaustion gap turned into a dead-cat bounce.

She watched the stock closely. Two days later the stock gapped again. It could either be a continuation gap or an exhaustion gap, she decided. Volume was heavy, about twice the 25-day moving average, so that offered no clue. The following day, when prices gapped again, she knew that the prior pattern was a continuation gap. Gina checked the price chart and using the center of the continuation gap as a midpoint, she measured from the trend low (point A in the figure) to the center of the gap. The difference was 5.50 (that is, 60.25–54.75). Adding the difference to the middle of the continuation gap predicted that prices would top out at 65.75, so she placed a stop at 65.50 and moments later, the stock was sold. That day, the stock climbed to a high of 66, slightly above the predicted price, and closed the day at 63.25. Not including commission charges, she made $7,500 in just 3 days. But she was not done. The large daily price range on high volume when she sold reminded her of a one-day reversal, but she was unsure. She decided to keep her options open and look for an opportunity to sell short. She followed the stock daily and when it closed below the support level at 61 she decided to sell the stock short and received a fill at 59. The next day she was surprised to discover that a large exhaustion gap had formed, dropping the stock down to 49, a $10,000 gain overnight. Knowing that the gap was in reality a dead-cat bounce, she changed tactics and did not immediately close out her position. Instead, she watched the stock bounce


4366_23.qxd

2/23/05

11:51 AM

Page 373

For Best Performance

373

upward for a few days then continue lower (as the formation predicts). Instead of getting greedy, she decided to close out her position and received a fill at 45, for an easy $14,000 profit in less than 2 weeks. If you think Gina was lucky, netting over $21,000 in 2 weeks, you are right. But her ability to correctly size up an investment opportunity and act on it quickly while taking steps to minimize losses goes a long way to explaining her luck. Some call it skill. Gina is a serious investor who leaves nothing to chance. She did not just jump in and start trading gaps after reading about it in some book. Instead she researched the formation, followed the stock closely, and developed a successful trading style that incorporates gaps. It worked for her, but it might not work for you.

For Best Performance The following list includes tips and observations to improve your selection of gaps that outperform. Consult the associated table for more information. • Review the identification guidelines for correct selection—Table 23.1. • The largest area gaps occur in a bear market with a downward breakout—Table 23.2. • Select breakaway gaps in a bull market near the yearly high. In a bear market, select gaps near the yearly low—Table 23.3. • Large breakaway gaps outperform small ones—Table 23.3. • Continuation gaps appear near the middle of the price trend—Table 23.4. • Continuation gaps appear near the middle of the time trend in upward breakouts, but about two-thirds of the way to trend end in downward breakouts—Table 23.4. • Review for specific trading tactics—Table 23.6.


Encyclopedia of Chart Patterns 23